A Taxing Situation: Exploring the Relationship between Home Values and Local Tax Revenues

January 2011

Jessica Dill: Welcome to the Federal Reserve Bank of Atlanta's Center for Real Estate Analytics podcast series. Today, Tom Cunningham, associate director of research at the Federal Reserve Bank of Atlanta, will be talking with Will Doerner from Florida State University.

Mr. Doerner and his coauthor, Keith Ihlanfeldt, presented their research on house prices and city revenues at the Atlanta Fed's conference " \The Crisis in Real Estate and Its Impact in Public Finance." This podcast will highlight their findings.

Tom Cunningham: Will, welcome.

Will Doerner: Thanks. Thanks for having me.

Cunningham: Local government revenues seem to have been hard hit in this recession. How have local tax revenues in Florida generally been performing over the last few years?

Will DoernerDoerner: I'll start by saying that "pretty poor shape" is definitely kind of a picture that you could paint, and one that the popular press has been depicting for us, especially in states like Pennsylvania, where you've recently seen municipalities declaring bankruptcy, and cities like Chicago trying to sell off public assets like public roads and parking garages. We got drawn into this current area of research because we wanted to verify whether or not those claims could actually be documented. We were able to amass a really big data set with property taxes and data about each parcel that property owners own and tie it together with public budgetary information.

The results themselves were pretty surprising. Starting in the mid-1990s and continuing for the next decade, real per capita tax revenues increased dramatically. And as the recession hit, tax revenues started to drop, although it did depend on the state of the region around our state. Typically, the larger cities are located in central and south Florida, and they seemed to get hit first, which probably isn't too surprising given the booming real estate markets, tourism, other industries that are typically associated with those areas. And while those large cities took a hit, medium and small cities were not nearly as affected, and across the state, the average was around 10 percent in tax revenue per capita falling between 2006—the peak of the bubble—and 2008. But smaller cities and places in the north part of our state actually recorded an increase in per capita tax revenues.

What was interesting about that to us was whether or not or why there was this non-uniform change across the state. Large states actually had more tax revenues in 2008 than they did in 1996, and the press has, anecdotally, attributed this to revenue changes from the housing market fluctuations in individual cities. Our main question was whether or not the housing bust actually caused these kinds of changes or could even be linked to those revenue losses.

Cunningham: So, are local government revenue shortfalls related to housing price changes? And to what extent could declines in property values be responsible for the problem?

Doerner: The short answer is that house prices have only had a limited effect on revenues for local governments. The reason it took us a bit of time to figure it out—the initial step was to decipher what's been going on in the local housing markets. We took typical house price indices from the S&P's Case-Shiller and the FHFA—the Federal Housing Finance Agency—and we saw that house prices started to shoot up around 2000, peaked in late 2006, early 2007. Unfortunately, those indices are only available regionally or for select MSAs or at a state level. With our Florida data though, we were able to construct indices for all 400-plus municipalities and all 67 counties. And when we aggregate them together at a state level, our Florida index almost perfectly matches the FHFA and mimics quite well the Case-Shiller.

The next thing we wanted to do was to break it down and use these city indices to see whether or not we could answer the question of how or if local house price fluctuations impacted local government revenues. Just like what we saw nationally, house prices soared and fell with the economy. But the changes in per capita in revenue are not actually completely attributed to the housing boom and bust. We document the difference between homesteaded and nonhomesteaded single-family homes in Florida markets. The difference that we've been picking up has arisen because of a constitutional cap that we have in our state on increases in property assessments. I should emphasize that this is an institutional detail, not a market peculiarity or failure. Several other states have some assessment restrictions, examples are Proposition 13 in California, Prop 2 1/2 in Massachusetts, and Ballot Measure 5 in Oregon. In Florida, our state assessment cap limits the taxable value of a house to grow only at 3 percent or the CPI, whichever is lower, for residents who claim a homestead exemption. The regulation itself is a big reason why the revenue changes cannot be completely attributed to the rise and fall in housing prices.

With some statistical tools, we were able to look at our indices and see how rising and falling prices have different effects on revenue. The data, as I mentioned earlier, can also be broken down into homestead and nonhomesteaded prices. The results show that nonhomesteaded properties are three times stronger in their effect on local government revenues than homesteaded properties, which tells us that this assessment cap has a strong influence by reducing the impact the house price can have on these local government revenues in the upswing and the downturn. To kind of draw together these ideas of house prices, revenues, and local governments, we began to notice two sets of interesting responses by local government officials as the house prices were fluctuating up and down.

Cunningham: You mentioned that political officials responded in two ways. What were those responses?

Doerner: Well, there's two sets of officials that we sort of started to divvy up our analysis up int. One is city council members, and the other one is property appraisers. And we can take them one at a time.

If we look at city officials first, the story that we can paint for everyone is that local economies were thriving, housing prices were soaring, and these city officials began to lower their millage rate by 2 to 4 mils pretty much across the board to please their constituents. And since house prices were going up, property owners were happy because tax rates were dropping. Local governments didn't mind because their tax collections were still growing as well. The problem that they ran into was when the economy turned sour and house prices started to fall, the officials couldn't simply move the millage rates back up to their previous levels. To make matters worse, the ad valorem taxes continued to climb because of our state's assessment cap.

The reason is because of the way our cap works. What happens is that the taxable value on your property can only increase at a rate of 3 percent, or the CPI, like I mentioned. If the market value of your house, though, increases much faster, you're fine, so the taxable value doesn't go up nearly as quickly. For homeowners, that sounded very appealing. The problem is that this gap widened quite a bit over time. Some houses accumulated a couple hundred thousand dollars in terms of a tax wedge, and what that meant is that property owners didn't stay happy when their home values started dropping 20, 30, or 40 percent because their taxes continued to climb. The fact that revenues still were going up as house prices dropped is why we had trouble linking house price movements to per capita tax revenue changes. Based on how the assessment cap functions, revenues can't go down until the just market value drops enough to be at the same level as that taxable value.

In terms of the behavior of the city officials when the house prices fell, officials tried to raise the millage rate to increase their per capita tax revenues, but homeowners, who are typically pretty active voters, cried out and millage rates have pretty much stayed stable since then. As all of this is going on, we saw a new phenomenon arise, which is property tax appeals, and that's where the other government officials, the property appraisers, come into play.

In Florida, we have elected county property appraisers, and they have to reassess properties every several years, like in most places around the country. But the difference is that they submit annual tax rolls, which means that our data is about as close as we are going to actual market transactions in terms of how the assessed values are reflecting the actual prices of properties. One thing that caught our attention was whether the appraisers themselves adjust their assessed values up and down at the same rates as we see the market move. In a perfect world, what we would have seen happen is these appraisers mimic the market with their assessed values. Our results showed that this didn't happen, though. The appraisers actually smooth out their assessments by not raising the values nearly as much as housing prices go up in the boom, and then as housing prices go down, they had even more trouble getting their assessed values closer to the market values. It was a pretty nice finding because this smoothing has been mentioned a lot in the literature, but it's usually shown with private appraisers, and it hasn't really been talked about in terms of public appraisers behaving in this way

Cunningham: So, what does your work suggest about property tax revenues going forward. Should we be looking out for something here in terms of local revenues?

Doerner: We're definitely interested in looking at these last two political influences, how they react as the downturn continues and then as the economy starts to recover. For quite some time, residential owners have built up that sizable wedge that I have mentioned, and even though millage rates had dropped and then stabilized, property bills had still been going up. The same bill could go down, finally, once property values drop enough to equal the assessment cap. So this kink, or corner solution, is where the values are equal—that's what we really need to be looking for because a few years back the statewide average was about 10, 12 percent of homesteaded properties being at that cap. Last year, the number rose to about, a little bit above 30 percent. Now if this trend continues, we're going to see per capita property taxes actually drop. Local governments definitely need to be aware of this because this tipping point could impact the types of revenues that they have.

They also need to be careful with discontent among property owners in response to recent political frustrations that have cropped up nationwide. A number of property owners have begun to appeal their property taxes. Marginally, it only costs an owner $15 to appeal here in the state of Florida, and it's about the same anywhere nationwide. Unsurprisingly, there's been a surge, then, in appeals as property values have dropped. To fuel the fire, a number of tax attorneys and real estate representatives have started filing appeals for other people at no charge, and the only catch is that they get to take a 20 to 50 percent cut of the first years tax savings.

To paint a picture of what's going on with these appeals and why we should worry about them: Dade County recently has put up on their website that they have about 143,000 annual appeals. It's a bit of an outlier because the entire state only gets about 200,000, but those numbers are huge, and those numbers are definitely changing over time. If we look statewide, there's about 131,000 appeals in 2007, lower than the 200,000 in 2008, and 94,000 in 2006. In the county where I live, we only had 200 residential appeals last year, 12 in 2007, and 1 in 2006, so it's definitely seeing a surge that's been catching on in this appeal process across the state. Mostly the appeals don't approved, but the courts still have to hear every case, and the property appraisers have to prepare their opinions and evidence for each appeal regardless if the appellant even bothers to show up in court.

For places like Dade County, having to take all these steps and all these preparations means that it takes 18 to 24 months just to complete all the appeals for a single year. So, as you can imagine, this nominal fee of $15 to file a property tax appeal is cheap for the appellant, but it can be really costly for taxpayers and other government entities within local communities.

There is evidence that these property appeals are not just isolated to Florida—they've actually become a nationwide trend. Some newspaper articles have reported success rates as low as 1 to 2 percent of all properties on a tax roll, which is pretty consistent with what we've seen across our state. A few other news sources have reported success rates of the filed appeals at about 20 to 40 percent. That's higher than what we're seeing. We're seeing a much lower 10 to 25 percent, depending on the year and the county. But in the end, this is a major problem because the tax representatives and these attorneys have been filing hundreds of thousands of appeals, and it's because its cost was very low. This is just what we need to be looking out for. What sounded good on paper, to have an easy and affordable tax appeal process, isn't necessarily what's working when local governments have to reallocate resources to deal with a new business tactic that exploits a policy where appellants can easily push cost on to the rest of the public.

Cunningham: That's a pretty interesting unintended consequence.

Doerner: No, it definitely is.

Cunningham: Will, thank you for your time.

Doerner: I appreciate it. Thank you for the offer to come here today.

Dill: This concludes our podcast with Will Doerner. For more podcasts on this topic and others, visit the Atlanta Fed's website at frbatlanta.org. If you have comments or questions, please e-mail podcast@frbatlanta.org.

Thanks for listening.