The past two years have seen a strong focus on taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform, specifically on individual and corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. es—with 2023 continuing the trend. But as housing prices are rapidly increasing, and property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. bills along with them, the property tax has come into the spotlight in many states. Because property taxes are a local tax with significant variation, it’s helpful to take a step back and examine the merits of property taxation, the policy tools available to keep tax payments in check, and the unique property tax burden placed on businesses.
Why the Property Tax?
Although taxes on real property often generate strong opinions, a well-structured real property tax generally conforms to the benefit principle (the idea in public finance that taxes paid should relate to benefits received) and is more transparent than most other taxes. The value of one’s property corresponds, if imperfectly, with the market value of the benefits governments provide, like roads, police and fire protection, and schools. In fact, some of these expenditures are self-reinforcing: a better school district can improve the value of a property.
Property taxes are also more economically neutral than most other modes of taxation. Because real property taxes are levied on an immobile asset, tax competition and tax avoidance activities are less pronounced than they would be under other taxes. While income taxes can discourage labor and investment at the margin, and many other taxes pick winners and losers by favoring or disfavoring a range of economic activities, property taxes have a much smaller influence on economic decision-making.
As a result, if a push to limit property tax burdens drives localities to shift to alternative revenue options, the net economic effect may be negative.
Property Tax Limitation Options
Nevertheless, taxpayers often have a point about property taxes rising too quickly—particularly now, with assessments skyrocketing in recent years. If property values jumped 40 percent in a particular jurisdiction over the past few years, it is highly doubtful that the cost of providing services to those households rose commensurately, or that the value of those services increased in line with the valuation increase. Property taxes tend to increase on autopilot, and state lawmakers can and should impose restrictions on their growth. But the devil is in the details: while a well-structured set of property tax limitations can improve tax competitiveness, poorly designed systems can distort markets and undermine fairness.
Property tax limitations generally fall into three categories: assessment limits, rate limits, and levy limits. All three categories can exist in more restrictive or more permissive forms; the mere existence of a property tax cap does not necessarily mean that property tax increases are restrained effectively. Each type also has a somewhat different goal.
|District of Columbia||X||X|
Source: Lincooln Institute of Land Policy, “Significant Features of the Property Tax.”
Assessment limits typically impose a constraint in the rate of growth of assessed value for each property individually, stipulating that annual increases cannot exceed a given percentage (or, sometimes, a certain amount above inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. ) unless the property is sold, transferred, or significantly altered. In their most aggressive form, assessment limits “roll back” or freeze any assessment increase, though more frequently they are designed to limit the rate of growth. A typical assessment limitation might, for example, cap increases in assessed value at 3 percent per year.
Assessment limits are aimed at constraining tax increases that are driven by rising home values instead of conscious policy decisions. They attempt to avoid inadvertently pricing someone out of their home when assessed values (and thus tax burdens) rise, as the owner’s ability to pay higher taxes may not have risen along with their home value.
Although well-intentioned, assessment limits create sizeable inequities over time without truly keeping property taxes in check. Under an assessment limit, an ever-increasing share of property tax revenue must be generated from newer properties, or (depending on when assessments reset) those that have changed ownership more recently or have been substantially improved. This can create highly unequal tax burdens across similarly situated properties, often penalizing the younger and lower-income homeowners that these limitations were designed to benefit. It can also create a lock-in effect, discouraging homeowners from selling or even improving their properties.
A well-designed tax limitation regime keeps taxes in check across the board, but an assessment limit tends to merely shift the tax burden from one class of homeowners to another.
|Existing Housing at Median Duration of Ownership, 2021|
|Los Angeles, CA||49.80%|
|New York City, NY||54.50%|
Source: Lincoln Institute of Land Policy, “50-State Property Tax Comparison Study.”
Rate limits impose a cap on property tax millages. In some cases, limits are placed on each taxing authority individually; other times, caps are imposed on each level of government or even in aggregate. Most rate caps are frozen at a particular level, but they can also limit the size of rate increases rather than prohibit them outright. Often a rate limitation can be overcome by voter approval of a ballot measure override or circumvented by adjusting assessment ratios or eliminating property tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the IRS, preventing them from having to pay income tax. s or abatements.
Compared to assessment limits, a rate limit is a more neutral vehicle for tax limitation because it does not result in substantially similar properties facing radically different tax burdens. It is, of course, possible for property tax burdens to rise—even dramatically—under a rate limitation regime, due to rising property values, new development, or changes to the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .
Levy (or revenue) limits are concerned with the actual amount of revenue raised by a taxing authority, imposing rollbacks or reductions to ensure that collections do not increase in aggregate above a given amount. Individual owners may experience an increase or decrease in tax liability based on changes in rate or assessed value, but aggregate collections are constrained. Levy limits are the most neutral and effective way to limit the growth of property taxes. They ensure that property tax burdens differ according to the relative value of properties, and avoid penalizing moving, improving a property, or beginning new construction, while still keeping property tax burdens in check.
Businesses and the Property Tax
While property taxes typically bring homeowners to mind, they have a large impact on businesses too. In fact, property taxes made up 38.8 percent of all state and local taxes paid by businesses in FY 2021, more than any other tax category.
Tangible Personal Property Taxes
Property taxes start to diverge from the benefit principle and cause economic distortion when they are levied on more than just real property. This is the case in the many states that include tangible personal property (TPP) in their tax bases.
In contrast to real estate, TPP includes anything that can be touched or moved. Taxes targeted at TPP often fall on business assets like machinery, equipment, and fixtures—which are part of a firm’s production process—and on their inventory—either of their own manufactured goods or those obtained at wholesale for sale to consumers as part of their core business activity. Firms may pass along the tax in the form of higher prices, to the extent that their competitors are similarly disadvantaged. Companies competing in a multistate market against competitors not subject to such taxes are placed at a competitive disadvantage: their peers elsewhere face lower tax costs on production.
When possible, state and local governments should look to shift from tangible personal property taxes toward revenue sources with broader, more neutral bases. To limit compliance costs for small firms, many states have de minimis exemptions, which eliminate businesses’ tax liability if their TPP valuation remains below a given threshold.
Split Roll Property Taxation
A tax roll is the official list of all the properties to be taxed. “Split roll” refers to the practice of applying a different tax formula, either a tax rate or an assessment ratio, to commercial properties than to residential properties.
For instance, a state could levy a property tax of 2 percent on assessed value across all classes but calculate assessed value differently depending on the class. To favor residential dwellings, a locality or state could classify assessed value on residential property as 10 percent of market value but as 20 percent of market value for commercial property. In this example, the levy on commercial real estate is effectively 100 percent higher on commercial real estate than on residential. Another way of creating a split roll is by levying different rates based on property class. Twenty states currently have some sort of split roll property taxation.
When business property tax rates are set independently of residential rates, they tend to be increased more frequently. In Denver, Colorado, for example, commercial property owners face effective tax rates that are almost four times as high as those on homestead properties. These penalties don’t just affect business owners but also many renters, since renters bear the economic incidence of property taxes on their rental units, which may be imposed at much higher effective rates than taxes on owner-occupied housing.
|Ratio of effective tax rates on commercial properties to those on homestead properties, 2021|
|Los Angeles, CA||1.01|
|New York City, NY||2.962|
Source: Lincoln Institute of Land Policy, “50-State Property Tax Comparison Study.”
The design of a state’s property tax system can affect how attractive that state is to businesses and residents. Lawmakers should ensure that any limitation regimes they pursue are truly effective, and that the state is moving away from nonneutral split roll systems and tangible personal property taxes as much as possible.
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