The Coming Property Tax Cliff Means More Bad News for Municipal Finances

A recently updated Federal Reserve staff working paper, "The Housing Crisis and State and Local Government Tax Revenue: Five Channels," notes that property tax collections "have been surprisingly resilient" during the financial crisis and downturn. That's in sharp contrast to the steep drops seen in other municipal revenue streams, as shown in the following chart from their study:

According to authors Byron Lutz, Raven Molloy and Hui Shan, the strength in property tax collections in comparison to those from other sources, including income and sales taxes, stems from "the long lag between changes in the market value of property and changes in taxable assessments and the tendency of policy makers to insulate revenues from housing price declines by raising tax rates."

"This propensity," they conclude, "makes it unlikely that property tax revenues will fall sharply in coming years."

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Unfortunately, as was the case before the current troubles began, these researchers (and others) are guilty of making the kinds of analytical mistakes that helped bring about the financial crisis in the first place. Simply put, they're basing some of their conclusions on unrealistic and backward-looking assumptions, and they're failing to take the bigger picture into account.

For example: How realistic it is to assume that property taxes won't be affected by the same economic pressures that have undermined other sources of revenue? While sales and income taxes have so far suffered most from weak labor markets, stagnant incomes and high consumer debt loads, is it a stretch to think that the long-running "jobless recovery" will soon take a big bite out of property tax revenues?

To be sure, tax assessments in many areas have ticked higher even as property values have fallen. But the recent electoral successes of the Tea Party movement and the growing popularity of fiscal conservatives like New Jersey Governor Chris Christie suggest taxpayers will resist efforts to boost rates even further.

In fact, unless one believes that real estate prices are poised for a sharp rebound -- which seems far-fetched in light of the large imbalances that still exist between supply and demand -- a quick read of another chart highlighting the historical relationship between the rates of change in house prices and property taxes suggests the latter is set for a substantial fall (note the slide that occurred in the early 1990s following the last great real estate downturn.)

With that in mind, the authors' other conclusion that "the downturn in state and local tax revenues was likely driven by the economic recession rather than the direct influence of the housing market downturn" is not exactly reassuring. The data they've presented suggest we've not yet felt the second blow of a predictable but devastating one-two punch to the finances of municipalities around the country.

Yet another reason to be wary of the muni bond market?