Jack Salmon recently ranked the major sources of state and local tax revenue according to two sensible criteria: economic growth and revenue volatility. Among the taxes examined as major revenue sources, property taxes impose the least economic distortion and are the least volatile. They stand out as a reliable source of government revenue.
Even a relatively efficient tax, however, can expand government’s fiscal capacity if the institutions governing revenue, spending and borrowing are left unchecked. Preventing abuse of the least bad tax, therefore, requires limits on both revenue and spending.
Why Property Taxes Have Low Revenue Volatility
Using Census Bureau data going back to 2005, Salmon finds that personal income tax revenue has a volatility score of 9.7 compared with 4.6 for sales tax revenue and 25.8 for corporate income tax revenue. Property tax revenue, with a score of 4.3, is the least volatile of the major state and local revenue sources. Corporate income tax revenue was more than five times as volatile as sales tax revenue, while individual income tax revenue was more than twice as volatile.
Revenue volatility partly reflects how readily taxpayers can change their behavior. In economics, elasticity measures how much behavior changes when a price changes. The more substantial the behavioral change, the greater the elasticity of demand with respect to price.
The same intuition helps explain tax base elasticity, which describes how much taxpayers change their behavior when a tax changes. A relatively elastic tax base gives taxpayers more ways to reduce the amount subject to a tax when the tax burden rises. Businesses may change investment or production decisions, consumers can alter purchases, and workers or firms can eventually relocate. A relatively inelastic tax base offers fewer ways to respond. Furthermore, tax base elasticity can be greater over longer periods because households and businesses have more time to adjust where they live and work (students of economics will recognize this as the second law of demand).
Because of their low volatility, property taxes present taxpayers with fewer opportunities to adjust. Land can’t cross a state line when property tax burdens increase through higher rates or assessments. A homeowner cannot relocate a house to the next county. Real estate is observable, assessable and difficult to conceal. This relatively low elasticity helps explain both why property taxation creates fewer behavioral responses than other taxes and why its revenue is unusually dependable.
That same relatively lower elasticity also helps explain why governments and their creditors value property taxes so highly.
The municipal bond market provides an especially useful illustration. Property taxes are commonly associated with local general obligation finance, and investors place value on their stability. Property taxes are often cited as the largest and most stable source of local government revenue, and they are also credited as a major factor influencing municipal credit quality and lower borrowing costs. Both investors and credit rating agencies warn that eliminating or substantially weakening property taxes could increase revenue volatility and cause a reassessment of municipal credit risk.
From the taxpayer’s perspective, those same characteristics make property taxes an unusually powerful instrument for fiscal extraction because taxpayers have fewer opportunities to escape a larger fiscal claim. The revenue source that appears the most efficient under a fixed-revenue assumption may also give a revenue-seeking government considerable capacity to tax and borrow.
The Lesson: Starve the Beast of Responsibility First, Then Revenue
This is where public choice theory, which assumes that those in politics act in their rational self-interest and respond to incentives in the same way they do outside of politics, adds something to Salmon’s ranking. In “The Power to Tax,” Geoffrey Brennan and James Buchanan challenged the conventional assumption that policymakers begin with a fixed revenue requirement and merely choose the least costly way to meet it. Their “revenue-maximizing Leviathan” model is designed to ask how tax rules themselves affect government’s capacity and incentives to raise revenue. Different fiscal institutions can affect how much revenue government seeks in the first place.
The lesson of “revenue-maximizing Leviathan” is that fiscal rules should be designed with the possibility of revenue-seeking behavior in mind. A rule that constrains one tax without reducing spending, borrowing or alternative revenues may end up redirecting fiscal activity elsewhere.
That last point is why Brennan and Buchanan made an important distinction between the choices made within rules and choices about the rules themselves. If we want to stop government from abusing property taxes durably, the argument must extend beyond property tax rates to the rules governing government’s responsibilities and spending.
To this end, priority-based budgeting—a paradigm forged by Washington Governor Gary Locke, operationalized for cities by Chris Fabian, and made workable for states by Jonathan Williams and ALEC—replaces the standard incremental budgeting system—adjusting previous budget amounts slightly for the new fiscal period—with budgeting based on how proposed spending aligns with the proper role of government. To achieve this, priority-based budgeting poses five key budget questions: What is the proper role of government? What are the essential services the government must provide to fulfill its purpose? How will we know if the government is doing a good job? What should it cost? When cuts must be made, how will they be properly prioritized?
This process takes more careful consideration than the standard process, but it can generate savings by removing policies that do not serve the core functions of government. It is most successful if it treats government as a single entity and does not exclude agencies or enterprises from the priority-based budget process.
If government has effective limits on the role it plays in society, limiting its ability to exploit an immobile tax base is much easier than simply capping tax rates.
How To Stop the Abuse of the Least Bad Tax
Fortunately, there is no shortage of options available to limit property taxes, spending and scope of government.
One option is Utah’s Truth in Taxation system, which prevents increases in assessed values from automatically producing equivalent increases in property tax revenue from existing property. A cap on the nominal tax rate alone cannot accomplish this. For example, a home assessed at $350,000 will have a tax bill of $3,500 in a state with a 1% property tax rate. If the home’s assessed value increases to $400,000 next year, the property tax bill becomes $4,000. The homeowner sees a $500 tax increase even though the tax rate remained at 1%.
Instead, Utah’s system calculates a “certified tax rate” designed to generate roughly the same property tax revenue as the previous year with adjustments for new growth. If the value of existing property rises, the certified rate generally falls.
Local governments remain free to collect more, but they must be subject to the Truth in Taxation process. Before adopting a rate above the certified rate, the taxing entity advertises the proposed increase, holds a public hearing and then takes a publicly recorded vote. This allows taxpayers to see that the government is choosing to collect more money rather than sneaking increases through assessment values.
The transparency that comes from Truth in Taxation addresses the revenue side of the problem, but not the underlying demand for spending. Broader revenue and spending limits would complement transparency with voter approval required above the ceiling. Property tax rates could then fall when assessment growth exceeds the permitted levy.
Any rule’s perimeter should also be broad enough to capture special districts, public authorities and tax-supported debt so that fiscal activity does not simply migrate outside the constraint. To ensure that the fiscal rules remain durable, government’s spending commitments must be constantly reassessed.
Conclusion
Salmon’s ranking captures an important truth: Property taxes can raise relatively stable revenue while producing fewer economic distortions than many alternatives. The same immobility that makes the property tax base attractive to economists, however, also makes it dependable to municipal bond investors and difficult for taxpayers to escape.
The answer is to place rules around the fiscal capacity that property taxes create. The least bad tax may still be the easiest to abuse. Keeping it the least bad requires constraining how government raises money and how much government promises to spend.
Thomas Savidge is a research fellow at the American Institute for Economic Research. Follow on X: @thomas_savidge.
