A Proposal for Meaningful Tax Reform

Edward J. Dodson

[An article submitted to the New Jersey newspaper, the Courier-Post, February, 2007. Although the paper indicated acceptance, the article was never printed]

As our elected officials struggle to respond to the widespread public reaction to rising property taxes, the measures under consideration are, in my view, consistently focused on expediencies that ignore both fundamental economics and even ethics.

My professional life has been spent in the community development field, partly as a researcher and partly as a program manager (20 years with Fannie Mae in Philadelphia and before that with a large regional bank). This work brought me to examine taxation as part of overall public policy as it affects community revitalization efforts and the ability to produce decent, affordable housing. What is not well understood is that the form of property tax imposed is an important component in the equation, as are all the other means by which government raises its revenue.

On numerous occasions over the years -- either before city council meetings, in public forums or in conferences attended by my professional colleagues -- I have offered the opinion that two policy changes should be strongly considered under any plan to reform the property tax. The first is allowing homeowners to apply to have their property tax payment capped based on a formula that looks at a combination of household income and liquid assets. The amount of property tax owed would not be reduced, only the amount that had to be paid annually. The unpaid amount would accrue as a lien on one's property, to be paid at time of sale or transfer of ownership. So long as property value is the basis for our tax obligation, this approach, I believe, is the fairest way to assure that long-term residents are not forced out of their neighborhoods because of property tax increases, while not requiring other taxpayers to subsidize indefinitely the cost of public goods and services to those whose tax payment is reduced.

The second proposal I have advocated is to give all communities, all school districts and all counties the option to adopt a two-rate property tax structure, under which property improvements would be gradually reduced (and, ideally, eliminated) over a stated period of time (e.g., ten years). At the end of this period, land value only would be subject to taxation. There are very good reasons -- both economic and ethical -- for moving to a land-only property tax base. Around thirty Pennsylvania communities (including the state capital, Harrisburg) and a few school districts in have adopted the two-rate structure under a state constitutional provision that permits this approach).

When land values are subjected to taxation at a rate that captures a majority of the potential rental value of the location, the landowner is financially motivated to bring land held to its "highest and best use" as determined by market forces. The cost of holding land becomes a meaningful cost that can no longer be significantly offset by speculative gains historically experienced by holding land from development. The taxation of land values stimulates a more competitive land market and results in a gradual reducing in land prices to developers, to businesses and to purchasers or residential property.

High land cost is one of the main reasons why many businesses find New Jersey locations less inviting than other states. Also, high land cost is also the reason we have such a crisis in affordable housing in so many of our communities. For the last few decades, many people have "cashed out" of their property (i.e., taken the increases in land value) and moved south or to the southwest, where land prices (and, therefore, housing and the cost of living, generally) are lower. To some extent, these options are disappearing, as land costs have skyrocketed all around the country, but especially in locations attractive to retirees. Moreover, household incomes for retirees in much of New Jersey are often too low to permit the majority of retirees to relocate. So, the elderly stay - although they may be forced to sell and "downsize" or move into rental housing.

What has not yet come to light in the debate over the property tax is that there is a calculable amount of revenue that is appropriately available to be raised - regardless of whether this fund is allocated to support schools or other public goods and services. The economics is not that complicated.

Every parcel of land has some annual rental value in the market. This value is created by aggregate public and private investment, rather than by what any individual landowner does or does not do on land owned. This annual rental value is capitalized by market forces into a selling price for land, with land speculation and the hoarding of land driving the price up and up even more. As a simple example, suppose you could lease a land parcel you own for $10,000 a year to someone or some business. If the expected rate of return on investments is 5%, the capitalized value of this land parcel would be 20 times $10,000, or $200,000. The owner today might ask a good deal more than this for the land because of the low effective rate of taxation that is generally levied on land (particularly vacant land, which is infrequently reassessed to reflect increases in market value). An annual property tax that approaches $10,000 would remove the profit from landowning. At the same time, the landowner would be encouraged to improve the land parcel to its "highest and best use" as determined by market demand, since those improvements would not be subject to taxation (i.e., when full land-value taxation is achieved).

Thus, there is some optimum amount of revenue that ought to be raised by the taxation of land values. I do not know what that amount is, but it is probably more than the total amount now being collected by the general property tax. The difference is that revenue would be raised from values created as a direct result of expenditures on public goods and services and no longer penalize owners of property improvements. Private investment in buildings of all types would no longer be burdened by taxation.

Economists who have studied the operation of land markets and how investment decisions are made agree this means of raising revenue would have a major impact on the revitalization of our urban communities and help to curtail sprawl. So, there are a number of very positive secondary effects of adopting the taxation of land values. The measure is often opposed, of course, by individuals and entities who hold land that is both valuable and underutilized (e.g., owners of surface parking lots).

A serious problem across the state is the infrequency of fair and equitable assessments. Property assessments are all over the map in terms of maintaining assessed values of like properties (with like land values) at the same percentage of current market value. I favor turning this responsibility over to a state agency rather than leaving this function to the counties or local government agencies. The state assessment agency would need a mandate to use market data to adjust assessed values on an ongoing basis, with adjustments made annually as appropriate. Importantly, as more and more New Jersey communities moved toward a land-only tax base, the cost of keeping land assessments current would be a fraction of the current cost of property assessment. The assessment cost savings would be significant where income-producing properties are concerned (whether residential, commercial or retail), inasmuch as none of the financial information concerning the property improvement would need to be captured and analyzed.

I have been retired from Fannie Mae since early in 2005. However, for the last few years in my position, one of my responsibilities was to travel to the cities in which the company had a field office to give presentations to groups of "stakeholders" on public policy choices and their implications for community revitalization and affordable housing needs. Within our Housing & Community Development group, my management team agreed with me that the above proposals were essential ingredients to our mission to help solve the problem of disinvestment in communities and expand the supply of affordable housing.

My fellow New Jerseyans are struggling to find permanent solutions to our rising cost of living, which includes the constantly rising costs of government. The above recommended measures offer structural alternatives to how revenue is raised today. These changes are not all that should be - and could be done - but are the core elements of a program of constructive, progressive reform.