Tax Capitalization

A lower tax rate directly increases the value of an economic asset, through the phenomenon known as "tax capitalization." Whenever the cost of holding an asset declines, its value increases, since the owner now will be required to pay less each year. This improvement of the owner's cash flow is capitalized into the price of the asset. Tax capitalization in property values is well established in commercial practice, the law of taxation and assessment, and the financing of homes.

The revenue analysis in this study explicitly includes estimates of tax capitalization. To not include tax capitalization would be to ignore fiscal reality, as well as Michigan law.

Commercial, Legal, Financial Use of Tax Capitalization

Investors in commercial properties, such as apartment and office buildings, routinely capitalize the expense and revenue streams predicted for a property when estimating its market value. For example, if an apartment building returned $12,000 a month in rent, and cost $10,000 a month in expenses and taxes, the margin of $2000 a month would be capitalized to estimate the market value of a property. To "capitalize" an income stream means to project out the cash flows into the future, and then add up the net present value (the value after discounting for the time value of money) of those flows. In the example, an income stream of $2000 a month or $24,000 a year might be capitalized at 10:1 to reach an estimated value of $240,000.[39]

Michigan taw relies on the capitalization of revenues and expenses, including property taxes, as one of three recognized methods of assessing property.[40]

Mortgage lenders use this principle in determining how much a home buyer can borrow.[41]

Thus, law, economic theory, and current practice ensure that a reduction in property taxes willresult in an increase in the value of property.

Tax Capitalization and Tax Revenue

Cut and Cap would reduce the tax expenses of holding a parcel of property, and therefore increase its value. The increased value will result in higher tax revenue than would have occurred without the increase in value. In this case, a 30% reduction in school operating tax rates would be capitalized into the true cash value of property across the state. This higher true cash value will then be taxed at the lower rate. Because of the higher true cash value, the change in tax revenue will be less than the 30% reduction in tax rate.

An Example of Tax Capitalization

For example, take a property with a true cash value (TCV) of $200,000, assessed at the SO% ratio at $100,000, and paying school operating property taxes of $3300 at the approximate statewide average of 33 operating mills. A straight 30% reduction in taxes would be .30 x $3300 = $990. Capitalizing this into the market value of the property, using a 10:1 capitalization ratio, yields additional TCV of $9,900, for a total TCV on the property of $209,900, assessed at 50% at $104,950. School property taxes of 53 mills (with the 30% exemption) would be .033 x 104,950 x (1-.30) = $2,424.[42] Other examples of tax capitalization, for representative properties and for typical properties in major Michigan municipalities, are given in Tables Six and Seven, beginning on page 25.

Comparing this with the original tax bill of $3300 shows how tax capitalization does two important things: First, it increases the value of the property. In this example, the property owner experienced an increase in wealth of $9,900. The property owner could recognize that immediately, through a home-equity loan or the sale of the property, or wait until later.

Second, the nominal reduction in property taxes is slightly smaller than the reduction in the tax rate. In this case, the actual tax cut was 73% of the rate cut. As a percentage of the value of the property, school taxes went down by the full 30%. However, the value of the property increased slightly, so the nominal dollar tax cut was smaller than 30%.

Tax Capitalization and the Assessment Growth Cap

In the simplified example above, we ignored the effect of the assessment growth cap on the individual parcel. Under Cut and Cap, the assessment cap would prevent much of the increased value from being taxed, until sold. However, the increased value could be tapped by a home-equity loan, or simply become part of the wealth of the homeowner.