The effect of property tax limitations on residential private governments: the case of Proposition 13.

INTRODUCTION

Despite having an unpopular reputation, in most jurisdictions property taxes form the primary source of local government revenue. The tax revolt era in the 1970s and the 1980s in the United States ushered in attempts by voters to limit the power of local governments to increase property taxes, attempts that still occur. In this paper I ask whether property tax limitations on local governments played a fundamental role in encouraging the formation of and the membership in homeowners' associations (HOAs). HOAs are a form of residential private government, that is, private institutions with the authority to provide public services to tax homeowners and to enact and enforce regulations. They are found primarily in planned developments and condominiums.

After laying out a framework for local responses to property tax limitation, I use data from the years surrounding Proposition 13, a stringent property tax limitation in California that took effect in 1979, to test the implications of the model. As motivation, Figure 1 shows the incredible proliferation of HOAs in California over the last 30 years. The horizontal axis graphs the number of associations incorporated by year. The graph shows that a surge in association incorporation occurred in the late 1970s and early 1980s. This coincided with the passing of Proposition 13, often considered the limitation that sparked the tax revolt throughout the United States. A key question is: Did the stringent conditions of Proposition 13 contribute to the tremendous growth of private governments? While the picture would suggest so, there were other forces at work at the same time. Roland (1998) and McKenzie (1994) note that in the late 1970s, the booming housing market and national changes in the construction industry also contributed to private government growth. (1) The challenge of this paper is to isolate the effect of the tax limitation.

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The empirical hypothesis is that cities responded to the proposition by encouraging the growth and membership in HOAs. Using a novel panel of municipal revenues and HOAs in California, the paper tests whether cities that were more property-tax constrained by Proposition 13 experienced higher rates of private government formation. The paper proposes several ways to define the degree of constraint Proposition 13 places on a city; one compelling finding is that Proposition 13's implementation meant that cities with high pre-Proposition 13 tax rates found themselves to be less constrained and exhibited slower private government growth.

I find that the level and the growth of private government membership significantly increased due to the imposition of Proposition 13. Magnitudes suggest that Proposition 13 results in an increase of 36 percent in new incorporations of private governments every year in an average city in California, relative to the period before Proposition 13. The strongest impact occurs in years immediately following Proposition 13 and attenuates thereafter. Finally, the paper describes several validation exercises that argue that it is differences in the impact of Proposition 13 that are driving the results.

The paper is organized as follows. The second section presents an overview of property tax limitations with particular emphasis on Proposition 13 and provides a theoretical framework to think about its connection to private governments. The third section introduces the empirical framework and describes the data. The fourth section presents the results. The fifth section concludes the paper.

PROPERTY TAX LIMITATIONS AND PRIVATE GOVERNMENT: BACKGROUND

The property tax revolt marked a fundamental desire by voters to limit the taxing and spending authorities of municipal governments. Shadbegian (1998) notes that between 1970 and 1992, one-half of the states in the country passed some kind of limitation measure. These took many forms: explicit limits on the property tax rate or level, a limitation on the amount of yearly tax increases, a limitation of the rate at which property value assessments can increase, and ceilings on the level and growth rate of expenditures. Together, these measures are known as tax and expenditure limitations (TELs).

TELs usually share several similarities regardless of where they are enacted. They are almost always statewide measures that affect most, if not all, local governments in the state. TELs are generally approved through statewide ballots. (2) TELs tend to be effective: local governments suffered large decreases in property tax revenue and they remain unable to increase property taxes beyond the mandated limit without voter approval. (3)

For this paper, I focus on California's TEL, Proposition 13, which is often cited as the first example of the property tax revolt. Its origin is often attributed to soaring land and property prices in California in the 1970s. While assessed values climbed, local governments were slow to lower the millage rate. Many homeowners saw double-digit increases in their property tax bills every year. Also the unpredictable housing market led to uncertainty about the size of future tax bills. Fueling public support were motivations to curb perceived overspending by local governments. In 1978 California voters approved Proposition 13 by a two-to-one margin, despite ominous predictions of drastic cuts to public services. O'Sullivan, Sexton, and Sheffrin (1995) estimated that the immediate effect of Proposition 13 was a 57 percent reduction in property tax revenue in the fiscal year 1978-1979.

Proposition 13 limited the property tax rate and changed the way taxes are collected. Before Proposition 13, each local agency (county, city, school district, and special district) set its own tax rate; the average homeowner's total effective property tax rate was 2.5 percent of market value just prior to 1978. Proposition 13 constrained a homeowner's total property taxes not to exceed one percent of market value, and a rule had to be devised to share the total tax revenues among local agencies. In addition, Proposition 13 limited the yearly increase in assessed value to two percent for those properties that did not change hands. The cap did not allow for growth in government revenues to match the pressures of increased demand for public services or the increasing cost of providing these services.

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Figure 2 shows how Proposition 13 affected municipalities statewide by substantially shifting the property tax rate distribution downward. The figure is a histogram of effective property tax rates in the fiscal year 1976-1977, two years before Proposition 13 took effect, and in the fiscal year 1981-1982, two years after. The property tax rate is calculated by dividing the property tax revenue by the market value of property in the city. (4) In 1976-1977, the average effective municipal property tax rate was 0.47 percent; in 1981-1982, the average had decreased to 0.27 percent. Compared to pre-Proposition 13 years, the distribution of tax rates shifted to the left, but it also got tighter.

Previous theoretical and empirical research has examined local government responses to TELs. Authors have suggested three main options to deal with the shortfall: cut expenditures, demand more intergovernmental transfers from the state, and find alternate sources of tax revenue in the form of fees and charges. I examine a fourth option: shift public responsibility to private governments.

Expenditure Cuts

An obvious response to a tax revenue shortfall is to cut the quantity or quality of local expenditures, a response borne out by research (Shadbegian, 1998; Figlio, 1998; Bice and Hoyt, 2000). As a result of Proposition 13, most cities in California reduced their spending, although not as dramatically as critics feared. State subventions cushioned cities' need to cut spending, but decreases were felt in most categories. O'Sullivan et al. (1995) noted that libraries, parks, and contributions to enterprises suffered the largest immediate cuts following Proposition 13. Infrastructure was also affected, as 90 percent of cities reported cutting back on capital improvement programs. On the other hand, in some cities, building regulation, public safety, and public works experienced increases following Proposition 13, reflecting a shift in priorities for city budgets.

State Aid

Another common response by cities is to turn to the state for help either through bailout funds to cover deficits or by shifting functional responsibilities back to the state. O'Sullivan et al. (1995) suggest that the blow of TELs is often moderated by generous state grants, while Shadbegian (1998) provides evidence that increased federal or state funds have acted as a substitute for local expenditure cuts. This is borne out in California. Passage of Proposition 13 was followed by a block grant from the state's surplus to cushion the decrease in property tax revenues. The grants, worth two billion dollars, were designed so that no local government would experience more than a ten percent loss in total revenue for the 1978-1979 fiscal year. Subsequently the state eliminated the bailouts and shifted a portion of property tax revenues from school districts to local agencies. In turn, the state increased assistance to school districts. This, coupled with a ruling on school district equalization, (5) effectively transferred control of school funding from the school district to the state. This is consistent with a finding, presented by Joyce and Mullins (1991) and Schwadron and Richter (1984), that following passage of a TEL there has been a gradual shifting of spending responsibility from local governments to state government.