Wednesday, September 16, 2009

The Dirty Little Secret of Property Taxes

News Flash: Property taxpayers and public officials have some conflicting interests. Property taxpayers would like their taxes to be as low as possible. Public officials are responsible for providing adequate services, which tend to cost money — property tax money. This perennial conflict is greatly amplified by the current declining real estate market. The dirty little secret of property taxes is that in a declining real estate market, property tax rates will tend to rise, even if the tax levy does not. High tax rates are inherently bad for property owners, because tax rates measure how steeply their wealth is taxed.

Although this post is in response to a story about Arlington School District taxes, every school district, fire district, town, and county in New York State has the same dirty little secret.

A front-page story by reporter John Davis in the Poughkeepsie Journal's August 27 edition appeared under the following provocative headline, “Arlington tax hike to be smaller than rate increase suggests”. The tone of this headline should raise suspicions that someone is trying to put something over on you — and someone is: Arlington School Superintendent Frank Pepe is attempting to spin the major increase in Arlington school taxes so that it doesn't sound as detrimental to taxpayers as it really is. It is part of Pepe's job to put the best face on a bad situation, and Pepe seems to do it well. Every statement attributed to Pepe in the article is factually correct. The article quotes Mr. Pepe as saying, “Very often people will confuse the tax rate increase with how much they will have to pay.” Pepe is so right! And ironically, it's just this confusion that he exploits to mollify property taxpayers into thinking that things aren't as bad as they sound. But they are as bad as they sound. Maybe even worse, as described below.

Balanced Reporting?

It's fine for the Poughkeepsie Journal to replay Arlington School District PR on its front page, but it's unfortunate that the story contained no hint that there might exist a different interpretation of the Arlington school tax situation than the one Mr. Pepe proposes. Poughkeepsie Journal readers would be better served by more balanced reporting, so that they can hope to understand what's really going on. I will try to supply some of that balance here.

Property Tax Rates Have Not Changed Much In Recent Years

To sort out Mr. Pepe's position and to see why it's disingenuous, you need to understand how property taxes work in New York State (and most other states). Property owners pay taxes according to their wealth, as measured by the market value of their property. The greater your wealth, the greater will be your property taxes. Many property taxpayers have the perception that their taxes have been dramatically increasing in recent years. This perception is incorrect in an an important way. What's really been happening in most cases is that property taxpayers' wealth — as measured by their property's market value — has been dramatically increasing for years. Property values in Dutchess County have roughly doubled in the last decade. Therefore, property owners likely pay double the tax dollars they paid a decade ago, assuming the same tax rate. This is because their “wealth” has doubled. This doubling of wealth would be realized if they sold their property.

The tax rate, measured in dollars per thousand dollars of market value, is the factor that determines how much tax you pay on your wealth — on your property's market value. I've already written two blog posts explaining the central role of tax rate. See The Tax Rate Is All That Matters and Fire Tax Rate. (School, town, and county property taxes work the same way as fire taxes.) Most property tax rates haven't changed a whole lot in recent years. It is your tax rate — not your tax bill — that measures how high your taxes are.

Increasing Property Values Allow “Painless” Increased Spending

Budgets and tax levies for school districts, fire districts, towns, and counties have dramatically increased over the last decade. These increases have been primarily financed by increases in the market value of taxable properties. In this way, local governments have been able to increase their tax levies each year without increasing the tax rate. This “painless” way of increasing tax levies without raising the tax rate has been working well.

Until now. This scheme of ever-increasing tax levies without increasing tax rates only works if property values keep going up. But property values aren't going up any more. In fact, they're going down. The Arlington story reports that property values have decreased in various parts of Dutchess County by 6 to 9 percent — and even by 23 percent in Pawling. And these decreases are for a valuation date of July 1, 2008 — before the economic meltdown. Property values have dropped further since then, but we won't see this effect on our taxes until Fall 2010.

The Dirty Little Secret

Falling property values put local governments in a bind. Even if they don't increase the tax levy at all, which is difficult to do when costs are rising, they will still cause the tax rate to increase. All other things being equal, the only way to prevent tax rate increases is to decrease the tax levy in proportion to the decrease in property values. Such measures tend to be beyond the capabilities of many local governments. The dirty little secret of property taxes is that when property values fall, tax rates tend to increase, meaning that taxpayers' wealth is taxed at a higher rate than before.

Interpreting the Arlington School District PR

Now we are in a position to correctly interpret the lead sentence in the Arlington story:
Most Arlington homeowners face double-digit increases in their school tax rates, but school officials said what most will actually pay is about a 5.2 percent increase due to reductions in assessed property values reflecting a sagging real estate market.
The first part of the sentence — the double-digit increases in school tax rates — is the most meaningful fact. The large tax rate increase is bad for Arlington property taxpayers, because it means that their wealth will be taxed at a 10+ percent higher rate than before. Period. That's all you need to know.

The second part of the sentence, “... what most will actually pay is about a 5.2 percent increase ...” is a bunch of smoke and mirrors, meant to exploit taxpayers' generally weak understanding of property taxes. Mr. Pepe is using the fact that you're paying somewhat fewer dollars in tax because you're not as wealthy as you used to be. See my recent post The Tax Rate Is All That Matters for a detailed analysis of this exact situation.

The Property Tax Situation Is Even Worse Than It Sounds

The Really Bad News is that there's nothing about this situation that's unique to the Arlington School District. The same principle applies to all local property taxing jurisdictions in Dutchess County and New York State, including fire districts, towns, and counties. All kinds of property tax rates are likely to increase this year, even if tax levies are held constant — which Arlington has not done. You will undoubtedly see other officials in many other property taxing jurisdictions attempt to use the same specious argument that Mr. Pepe used.

And next year will be even worse. The reason is that this year's decreased property values are based on a valuation date of July 1, 2008 — before the economic meltdown which caused property values to fall further. Therefore, property tax rates will likely increase again next year.

And what about the longer-term future, when property values can be expected to rise once again? Will the inflated tax rates come down to previous levels? Not necessarily. After a couple of years of higher tax rates, governments will find it politically easy to get away with saying, “We're not going to increase taxes next year.” This claim means nothing other than “We're not going to increase tax rates next year.” In other words, we may be in for a permanent increase in property tax rates, that is, a permanent increase in the rate at which our wealth is taxed. That's the worst part of why the tax rate increase is such bad news. That's why we should reject the spin of government officials about the amount of dollar increases in tax.

Tuesday, September 15, 2009

The Tax Rate Is All That Matters

Whether it's sales tax or property tax, the only thing that matters is the tax rate. The tax rate tells you whether your taxes are high or low, increasing or decreasing, and by how much. This post explains property tax rate (for fire tax, school tax, town tax, county tax, etc.) by comparison with the more-familiar sales tax rate.

A Simple Sales Tax Example

Let's say you go into a used car lot, and a salesperson shows you a car for $10,000. If you buy the car at that price, your sales tax, using Dutchess County's 8.125 percent sales tax rate, will be $10,000 times 0.08125, or $812.50. But suppose you talk the salesperson down to $9,300, a 7 percent decrease. Then your sales tax will be only $9,300 times 0.08125, or $755.63. The sales tax amount is 7 percent less because the cost of the car is 7 percent less. Fair enough.

Now let's add a game-changing hypothesis: When you go back to the dealer the next day to buy the car for $9,300, suppose a new sales tax rate has just gone into effect: The 8.125 percent sales tax rate has been replaced by a 9 percent sales tax rate. So your sales tax becomes $9,300 times 0.09, or $837.

Your used car salesperson tries to mollify you, “That $837 is only $24.50 more sales tax than the $812.50 you would have paid yesterday — if you'd bought the car then for $10,000. That's only a 3 percent increase.”

You don't fall for this specious logic. Your plan was to buy the car for $9,300, not for $10,000. As far as sales tax is concerned, the only thing that really matters is the fact that the sales tax rate increased from 8.125 percent to 9 percent. So the $9,300 car is costing you $81.37 more in sales tax today than it would have cost you yesterday (a 10.8 percent increase), because the sales tax rate increased by 10.8 percent. The old price of $10,000 has nothing to do with the situation. It is the sales tax rate increase that's costing you more money than you would otherwise have had to pay.

Sales Tax Versus Property Tax

The main difference between sales tax and property tax is that you pay sales tax because you bought something (a car), but you pay property tax because you own something (your house). Sales tax is charged at the time you buy something, while property tax is charged every year that you own something. In both cases, the only thing that matters is the tax rate. The tax rate is used to compute the amount of your tax. The amount of your tax is simply the monetary value of the thing you bought or own times the tax rate.

Sales tax is usually expressed as a percent, like the 8.125 percent Dutchess County sales tax. Property tax could be expressed as a percent, but for historical reasons it's expressed as dollars per thousand dollars of market value. For example, a property tax rate of $10 per thousand dollars of market value could just as well be expressed as 1 percent. So a property tax rate of $10 per thousand dollars of market value means that 1 percent of your wealth (your property's market value) is paid to the government. Each year.

A Simple Property Tax Example

Unlike sales tax, property tax is paid every year. The amount of tax you pay each year is the product of your market value and the tax rate. Either or both the market value and the tax rate can change from year to year. Let's say your property had a market value of $200,000 last year, and that last year's school tax rate was $10 per thousand dollars of market value. Then last year's school tax would have been $200,000/$1,000 times $10, or $2,000. (I'm neglecting here the confounding effect of New York State's School TAx Relief (STAR) Program, which essentially subtracts a fixed dollar amount from school taxes for qualifying taxpayers.)

This year, because of declining real estate values, your property is only worth $186,000 on the open market, a 7 percent decrease. But this year's school tax rate has increased to $11.08 per thousand dollars of market value, a 10.8 percent increase. Therefore, your school tax this year is $186,000/$1,000 times $11.08, or $2,061. In summary, this year your property tax bill is $61 greater than last year, or about 3 percent greater. Now, here's your test: How much has your school tax rate increased this year?

If you answered “3 percent” you haven't been paying attention. Go back to the beginning of this post and read again. This time notice that in both the sales tax example and the school tax example, the value you're taxed on decreases by 7 percent, but the tax rate increases by 10.8 percent, resulting in a net increase in tax payments of about 3 percent.

The correct answer is that your school tax rate has increased by 10.8 percent, from $10 to $11.08 per thousand dollars of market value. Once again, the fact that you're only paying 3 percent more dollars is a reflection of the fact that you're paying taxes on a property that's worth 7 percent less.

Why does it matter? Why should you care?

This matters because politicians will try to fool you into thinking that somehow a 10.8 percent increase in property taxes is “really” only a 3 percent increase. Indeed, they already have. My next blog post will show how the Arlington School District is doing this.

Footnote on Measuring Property Tax Rate: Unfortunately, the property tax rate, measured in dollars per thousand dollars of market value, is generally not readily available. Instead, tax bills and public officials tend to talk about property tax rate measured in dollars per thousand dollars of assessed value. These two measures of property tax rate are not quite the same thing, and you may be in a world of trouble unless you understand the difference between the two. Short answer: They're related by the equalization rate. For a more detailed explanation, see pages 6—7 of Document #5 at my companion website.