Thanks to @devin_mb for help on this post.
From the day it passed, Prop 13 has sparked intense debate over its impacts on city finances and land use decisions. For readers outside California, the chief provisions of Prop 13 are that it (a) caps property taxes at 1% of assessed value and (b) caps annual property tax increases at 2%, a value frequently less than inflation and almost always less than the annual appreciation, until the property changes ownership. There are, of course, a lot of complicating factors, but for our purposes, good enough.
Most commentary on Prop 13 focuses on the distortionary effects that accrue over time when a property does not change hands, due to the 2% increase limit. Because the land is assessed well below market value, owners pay little in taxes, and are given a disincentive to redevelop, which would trigger reassessment at a much higher value.
However, the 1% of assessed value cap might work to set an artificial floor for the price of new housing construction, and that’s the mechanism I want to examine today with a highly simplified model.
Consider a two-city world, where all households are the same, and all housing units are the same. House value appreciation is constant, as is the rate of housing turnover. Also assume there is no need-based state assistance to cities. Housing prices vary only by location. One city is by the ocean, so it has high housing prices, while the other is inland with a hotter climate, and has low housing prices. Now suppose that each new housing unit must generate $4,000 in taxes, as of initial sale, to pay for its city services.
In a normal region, cities would raise the revenue by setting the tax rate as needed. This typically means that cities with cheaper housing have higher tax rates, so as to raise the same revenue*. So, to cover public services, the beach city with $500,000 houses would set its tax rate at 0.8% and raise $4,000 per house, while the desert city with $200,000 houses would set its tax rate at 2.0% and raise $4,000 per house.
Now let’s impose Prop 13’s 1% cap. The $500,000 house city is fine, but the $200,000 house city can only raise $2,000. They’re hosed: new housing that sells for $200,000 is an inexorable drain on municipal finances. To survive, the city must do everything it can to discourage construction of houses at $200,000 and drive the cost of housing units up to $400,000. One way to do this is with minimum lot size zoning or minimum housing unit sizes.
The California Legislature supposedly gave cities a way out of this problem with Mello-Roos fees. In essence, Mello-Roos fees are like a business improvement district: properties within the district pay an additional fee to fund new infrastructure like new schools. So theoretically, if you want to offer houses at $200,000, you can tax them at 1%, slap on a Mello-Roos fee equivalent to an additional 1%, and you’re good to go.
In reality, this only works if your entire city is one giant Mello-Roos district, which it’s not, because the city almost certainly includes already developed areas. Suppose then that our desert city is half developed, and half under construction today. The old side has taxes capped at 1%, while the new side of town is a Mello-Roos district and so pays 1% plus the Mello-Roos rate. Suppose for now that the Mello-Roos fee is set at 1% for a 2% total tax on new houses.
From a property tax perspective, a $400,000 property paying 1% is the same as a $200,000 property paying 2%. But from a buyer’s perspective, the math is different; the additional tax devalues the property only by the present value of the amount of the Mello-Roos fees. For example, a $400,000 30-year mortgage at 5% will cost you $26,000/yr; add in an annual 1% tax and that’s $30,000/yr. For the same $30,000/yr, assuming a 2% tax rate (1% property tax plus Mello-Roos), you could only get a $353,000 house.
Back to our example. We’d like to find an equilibrium where tax revenue averages $4,000 per household. If we add a 1% Mello-Roos fee, then house prices will have to rise for both old and new houses: the equilibrium that satisfies everyone in this case is for the old houses outside the district to be priced at $289,500 and the new houses inside the district to be priced at $255,500. The cost to the buyer (in mortgage and taxes) is about $21,900/year in each case, so households are indifferent between the new and the old homes. The house outside the district pays $2,895/yr in taxes and the house inside pays $5,110/yr, so the city collects $8,005/yr in total, or about $4,000/yr for each household.
In this example, we’ve raised the requisite tax revenue, but houses are alarmingly expensive: up over 25% from the base of $200,000. Charging a higher Mello-Roos fee to the new houses can bring prices back down. If you make the Mello-Roos fee 2%, the equilibrium is $237,500 and $187,500, and the combined housing and tax burden has been driven down to $17,800/yr, about what it would be in a city with $200,000 houses and a 2% tax rate.
While it might seem like we’ve got a Prop 13 workaround figured out, note that this example assumes there is one house inside the district for every one outside the district. This is only plausible for a young, rapidly growing city, as an established city will have many more existing houses outside the district and Mello-Roos districts expire over time. If we assume a 2% Mello-Roos fee and 20 houses outside for every one inside, the equilibrium is $376,000 for an old, low-tax house outside and $296,000 for a new, high-tax house inside. This equates to a combined housing and tax burden of $28,200/yr – almost as high as in a city with $400,000 houses, a 1% tax rate, and no Mello-Roos.
In other words, it doesn’t matter that Mello-Roos fees make it possible to have $200,000 houses that generate enough tax revenue. A city can’t allow the houses outside the Mello-Roos district become too affordable without ruining municipal finances. Newer cities with rapid growth and a large percentage of houses covered by Mello-Roos districts can make the math work, but legacy cities can’t, and in time, all new cities become legacy cities. Thus, Mello-Roos makes it possible to fund new master planned suburban growth in the urban fringe, but offers little help to infill and affordable housing in cities.
Note that in this post we have treated Mello-Roos fees as a perfect substitute for property taxes, but in fact, they are more restricted in what they can be spent on. If anything, this simplifying assumption skews the analysis in favor of affordability, because it allows Mello-Roos fees to cover shortfalls in revenue raised on properties outside the district. In fact, I see no reason to believe that relaxing all of the simplifying assumptions in this model will yield different results.
*In reality, rich cities will raise more money so they can buy things like rabbit statues, but for now, assume they both target the same revenue.
Let's Go LA 
Newer cities with rapid growth … can make the math work, but legacy cities can’t, and in time, all new cities become legacy cities.
And that’s why Prop 13 is basically a Ponzi scheme. Its continued viability is based on the idea that there’s always another round of suckers just waiting to move to California and pay for the previous rounds. Except that obviously can’t keep going on forever. Another Prop 13 problem: cities want commercial development rather than residential, because residents want expensive things like schools, so you get things like Mountain View allowing a huge new Googleplex, as long as it includes absolutely no new housing, because that housing (in isolation) would be a net drain on the city’s coffers.
There’s nothing set in stone that says that government has to be funded through property tax. Government can be funded through income tax as well, which is a better way of taxation than property or sales tax. The positive of Prop 13 is that it provides, through acquisition value taxation, a reliable source of revenue for governments which does not fluctuate wildly. It also eliminates the need for tax assessors to constantly revalue property and face assessment appeal hearings. The concern might be that it punishes short term buyers and introduces stickiness into the housing market, but like rent control, some people look at this as a feature, not a bug.
Reliably low, amirite? The crux of the argument here is the 1% cap, not the lack of reassessment or limited annual increase (which are assumed away to simplify things). Indeed, Massachusetts has a similar law but with a 2.5% cap, and its cities aren’t nearly as screwed.
The difference is that in MA, the 2.5% increase cap is applied at the level of the whole town, rather than at the level of the individual property. So assessments are more or less in line with reality, and completely independent of when you bought, and the town just has to adjust the overall rate to stay under the cap.
Unfortunately, Prop 13 makes it impossible for the state government to raise the income tax or the sales tax (because it requires a 2/3 majority) and makes it impossible for localities to do so either (for the same reason), and the state doesn’t allow localities to raise income taxes anyway.
Prop 13 is actually unconstitutional. The 2/3 rule was a wholesale constitutional revision which cannot be passed by initiative. However, this was never challenged in state court, as far as I can tell.
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The problem with Prop 13 is that its benefits accrue to a group which overall is the most affluent in the state–longtime homeowners. There are some longtime lower income homeowners who benefit, but they’re a small proportion of the beneficiaries. From any kind of equity perspective, the tax break goes to exactly the wrong people.
California cities are not permitted to levy income taxes, but they can–under restrictive rules–levy property and sales taxes. So state law would need to be changed in order to have local income taxes, which certainly have the potential to be fairer.
Politically speaking, though, long term homeowners vote, and so do their children. The real benefit of Proposition 13 does not go to homeowners but to commercial property owners and landlords. Many of them are small businesses, like car dealers and liquor store owners, who also are politically powerful.
I could see revenue neutral Proposition 13 reform – for example, if you convert to the split roll, the growth in the commercial roll above regular inflation would be diverted into increasing the homeowner’s exemption, for instance. Increasing the homeowner’s exemption by decoupling commercial taxes would result in a tax cut to many homeowners but would run the risk of California being portrayed as even more business unfriendly.
Beware of solutions that only increase complexity (e.g. diverting commercial property tax revenue to a restricted purpose) and will have unintended consequences. That’s how we got to the Rube Goldberg state/local financing system we have today: it’s been reformed, and reformed, and reformed by generations of initiative voters.
And… property tax as a source of state, and especially local, revenue has many desirable features. It is stable and predictable. It is progressive against wealth distribution. It is easier to collect. It is a very good nexus between long-term capital requirements of infrastructure and the actual beneficiaries of that infrastructure.
Just because of a few corrupt assessors in the 1970s, Californians have constructed an extraordinarily complex and dysfunctional financing system that bypasses the obvious benefits of property tax revenue in favor of regressive and unpredictable sales, capital-gains and other income-driven taxes.
By the way, Mello-Roos districts are able to fund ongoing operations. But, they must be renewed periodically, unlike property tax – based bond proceeds expenditures.