Narrator: When we think about property taxes, we usually think about what homeowners pay. But from a finance perspective, property tax revenues are something else entirely. They’re one of the largest and most stable financial assets held by local governments. In finance, complicated assets are valued by tracing them back to the cash flows that ultimately support them. A firm is worth the present value of its dividends. A house is worth the present value of its rents. So what is the fair value of a government’s claim to collect property taxes year after year?
Anthony Lee Zhang: And so the interesting thing about property taxes as a financial asset is they’re a compound claim. Property taxes are a claim to a fraction of house prices, which are then a claim to rents. And essentially the mathematical problem that we have to solve in figuring out what is the price of property tax revenues in an efficient market is unraveling this compound claim and ultimately reducing property taxes to some kind of claim on rents.
Narrator: That’s Chicago Booth’s Anthony Lee Zhang. He and his coauthors derive a pricing formula showing that the present value of property tax revenues, the government’s claim to collect taxes over time, can be expressed as a weighted sum of expected future rents with greater weight placed on rents further in the future. In other words, property taxes are not just a steady annual payment; they’re a long-term backloaded financial claim.
Anthony Lee Zhang: Seemingly small property taxes can extract a very large fraction of the present value of the rent stream generated by the house. So to make that concrete, consider a house in Chicago that costs say $400,000, right? With Chicago property tax rates, the annual tax you’re paying on that house could be anything in the range of, say, $10,000 a year. And then a simple calculation is just you can capitalize what is the value of the property taxes? What is the value of a financial asset that pays you $10,000 a year? And you get a number that’s well in the range of $100,000–$200,000. So you basically realize that put one way, your house would be worth basically something like 30–50 percent more if you didn’t have to pay those property taxes.
Narrator: A 1 percent tax may sound small, but collected year after year, it compounds into something much larger in present-value terms. That’s the first implication. Property taxes also carry significant interest rate risk.
Anthony Lee Zhang: A core idea in finance is the idea of duration. And duration basically says that the further your claims are into the future, the more sensitive your claims are to interest rates. For example, a one-year Treasury bill is going to be much less sensitive to interest rates than a 30 year Treasury bond, intuitively, because if you buy a Treasury bond that locks in a rate of say 4 percent or 5 percent, then if interest rates change, you’re locking in that rate for a longer time. Now, what our characterization of property taxes have to do with this is that notice that the government holds a very backloaded claim on rents. In our characterization, we showed the government basically has a deal where it owns more of the rents further into the future. And what does that mean? It means the government holds an extremely backloaded financial asset. In a simple calibration, we try and calculate, what does this imply for the interest rate sensitivity of property tax revenues? We find that the duration of property tax revenues is in the ballpark of 35 years. Property tax revenues are as sensitive to interest rates as a 35-year bond. And this is essentially the most interest-rate-sensitive financial asset in the universe of financial assets.
Narrator: That finding reframes how we think about local government balance sheets. Much of the existing discussion focuses on pension liabilities and their exposure to interest rate movements, but this analysis suggests that the dominant force may lie elsewhere.
Anthony Lee Zhang: Property tax revenues are both larger than pension liabilities on average in the US by a factor of around two and three to four times more sensitive to interest rates. When interest rates go down, the value of property tax revenues goes up by around six times as much as the value of pension liabilities goes up. And what that means is that local governments, our analysis shows, overwhelmingly benefit from fallen interest rates because of the massively-high-duration, interest-rate-sensitive asset that property tax revenues constitute.
Narrator: Property taxes are not just large; they are long. And because they’re long, they’re powerful. And that leads to a third implication, one that extends beyond asset pricing and into public policy.
Anthony Lee Zhang: We’ve shown that local governments own more of the rents in the future than in the near term. What this means is that local governments have a stronger incentive to make investments in the far term that pay off in the far term than in the near term. If the local government has a choice between running a festival, which is going to maybe increase the amenity value to residents next year versus build infrastructure or build a park or something, which is gonna have a long-run effect on values, intuitively the park is gonna have a larger and more lasting impact on property tax revenues. And our analysis formalizes this and says that the local government actually has a stronger incentive to make these longer investments than to make short-run investments that kind of boost values in the near term but don’t have any lasting value.
Narrator: Because housing markets are forward looking, long-run investments can raise property values today. And when property values rise, so does the value of the government’s claim on future rents. In theory, this structure may counteract short-term political incentives.
Anthony Lee Zhang: If a politician who is going to finish his term makes an investment that increases, that only pays off 10 or 20 years in the future, the interesting thing is that the market is forward looking and makes the price of houses higher today to reflect those investments, meaning that the politician actually captures some of the value of investments today. Our analysis is done in a very stylized, very simplified model, essentially the textbook model, where we ignore a lot of real-world issues that get in the way of efficient markets. But through the caveats, we think that the value of these models is in highlighting intuitions around how these assets behave, that although they may not be completely quantitatively realistic, are useful in guiding how we think about these financial assets.
Narrator: Property taxes are more than revenue. They are a long duration asset. Viewed that way, they reshape how governments understand interest rate risk and how they approach long-term investment.
