Effects of Property Taxation on Development Timing and Density: Policy Perspective

Different facets of the property taxation policy debate move in and out of focus according to current policy concerns and academic interests. Recently, the property tax has been discussed as a factor contributing to suburban sprawl, exclusionary zoning, the current crisis of housing affordability in coastal U.S. metropolitan areas, and housing market volatility. In the context of local government, the thriving literature on capital tax competition treats property taxation implicitly. A generation ago, debate focused on the extent to which the property tax, in the presence of local zoning, is a benefits tax. This followed soon after another debate concerning the general equilibrium incidence of the tax, pitting the orthodox view that the tax is regressive against the revisionist view that the tax burden falls on the owners of land and capital.

This paper looks at yet another facet of the policy debate over property taxation that harkens back to an even older literature—the property tax's discouragement of density. According to the classic view, the property tax is an equal-rate, ad valorem tax on the land and capital services used in the production of structure services.¹ Land services are inelastically supplied, so that the property tax component that falls on land generates no distortion and is shifted back to landowners. Capital services, in contrast, are elastically supplied, so that the property tax component that falls on capital discourages capital, generates distortion, and is borne by the consumer. Property taxation therefore discourages density (capital intensity) while land taxation does not.

This classical theme is revisited here from the perspective of a relatively recent theoretical literature on property development that takes into account the durability and immobility of structures and examines property taxation effects using deterministic capital asset pricing theory. This literature examines the profit-maximization problem of an owner of vacant land who must decide when and at what density to develop the land.

This paper has two overriding objectives: 1) to urge those who suggest property tax reforms not to ignore how their proposals affect the efficiency of development timing and density, and 2) to provide a more sophisticated (yet still intuitive) framework for thinking about the proposed reforms' effects on the efficiency of property development and redevelopment.

Setting the Stage

Over the past thirty years, the literature on taxation's effects on the timing and density of development has greatly expanded.² The recent literature's distinguishing feature is its explicit treatment of the durability and immobility of structures. The basic model looks at a competitive landowner who owns undeveloped land. Once he or she develops the land at a certain density, it remains at that density forever. The landowner chooses development timing and density under perfect foresight. Taxation affects these margins of choice. This model has been extended to treat redevelopment (but without taxation), uncertainty, and the general equilibrium of a growing city.³ This paper develops the partial equilibrium model without uncertainty and without redevelopment.⁴

Model without Taxation

Consider an atomistic landowner who owns a unit area of vacant land and has perfect foresight concerning the future time path of structure rents. Once a structure is built on the land, it remains there as it is forever; the structure does not depreciate, nor is redevelopment possible. To simplify, it is assumed that the interest rate, construction technology, and price of capital remain constant over time, and that rents increase over time. The following notation is employed:

• T: development time;

• k: capital applied to the land;

• r(t): rent per unit floor area of structure at time t;

• q(k): the floor-area ratio as a function of capital applied to the land;

• p: price per unit of capital;

• i: interest rate.

q(k) is termed the structure production function and exhibits positive but diminishing returns to capital. The landowner chooses development time and density so as to maximize the present value of rents minus the present value of construction costs:

The timing first-order condition is

which states that it is profit-maximizing to develop the site when the benefit from postponing...