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 eachyear. 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.
Michigan law relies on the
capitalization of revenues and expenses, including property taxes as one of
three recognized methods of assessing property.
Mortgage lenders use this
principle in determining how much a home buyer can borrow.
Thus, law, economic theory,
and current practice ensure that a reduction in property taxes will result in an
increase in the value of property.
Tax Capitalization and Tax Revenue
"A" 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, the 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, but at the lower rate.
Because of the higher true cash value the change in tax revenue will be
less than the change in the tax rate.
An Example of Tax Capitalization
For example. Take a
property with a true cash value (TCV) of $200,000, assessed at the 50% ratio at $100,000, and paying
school operating property taxes of $3300 at 33 operating mills. A straight 30% reduction in
taxes – dropping down about 10 mills – 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. The new school taxes of 23 mills would be .023 x
104,950 = $2,413.85.
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. 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 "A," 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, a mortgage refinancing, or simply become part of the wealth of