David R. Henderson  

Explaining Burden of a Tax with Words

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Two days ago, I was talking to one of my allies in our recent successful fight against an increase in the property tax in Pacific Grove. He commented that the tax increase would have hurt renters too because landlords would have "passed on" the increase.

I suddenly figured out a way to explain to him why that wouldn't happen. Here's what I said:

Rents are determined by the demand for and supply of apartments. The only way rents will change is if the demand changes or the supply changes. The property tax increase won't affect demand. (Later I realized that I was assuming that the use of the taxes--to buy computers for students--won't affect demand. It could if the computers enhance education, making schools in Pacific Grove more attractive. But I think the money will be pretty much wasted.) It also won't affect supply either. The supply of rentals in Pacific Grove is pretty much fixed in the short run. In the long run, the increase in property taxes could discourage replacement of deteriorating apartments but that probably wouldn't happen, with that relatively small tax increase, in less than 5 years. Bottom line: No increase in rents.

The guy I explained it to said, "Oh, yeah, I get it."


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COMMENTS (31 to date)
Himanshu Sanguri writes:

In India, most of the properties are owned on the mortgage. Buyers take the EMI, property tax and society maintenance charges aggregation to decide the rent amount. Demand& supply affect the rent amount too.

Pajser writes:

Tax make landlords poorer; their demand for money increases and they become willing to supply same apartment & time for less money than before.

David R. Henderson writes:

@Pajser,
No. With the same apartments, the supply is the same. No effect on price.

Brian writes:

David,

I don't get it. Why doesn't demand for rental properties change? If owning a property becomes more expensive because of the tax, fewer will buy, meaning more need to rent. Also, with the reduced profit margin for landlords, fewer would be willing to buy or build a property for the purpose of renting. Wouldn't that push up rents until an equilibrium is reached?

Troy Camplin writes:

It will cut into profits. And when it cannot cut into profits, it will cut into amenities, etc the landlord had been providing.

Mark Rand writes:

You're mistaken, unless 100% of the landlords are presently making a decent profit. A tax increase will force any landlords who are barely covering expenses to either raise their rents or sell their properties. (Another possibility is that they simply lose the property when they can't cover the mortgage.) If they sell, the new owner might either take the property off the rental market (reducing supply) or charge a rent sufficient to cover expenses.

Maybe the number of landlords so affected is minuscule, in which case the overall effect might be too small to be measured. That however is something that should be demonstrated empirically, not simply asserted.

Himanshu Sanguri writes:

One more observation, in India, we have different property tax rates in different states. However, if I compare the property rents in three major IT hubs in three different states, and I have observed that rents are directly proportional to the property tax rates. Moreover, in some special economic zones where government provides subsidies in property tax rates, rents are on lower side as compared to the no subsidy zones. There can be n number of factors that do affect the property rent rates, and I can clearly see around that the property tax is one of the major one.

David R. Henderson writes:

@Troy Camplin,
Of the mistaken comments above, I'm singling yours out because I know you're economically literate.
You're right that it will cut into landlords' profits. That part is correct. But the only way it can affect rents or amenities is if it shifts supply. With a highly inelastic supply, it will do that little or not at all.

Bob Murphy writes:

David,

Something is not sitting right with me on this, and maybe you can help me figure it out. I think I agree with your conclusion, but not with the way you are reaching it (or at least, with your further comments down below the post).

At times you are saying the supply is inelastic, which (to us economists) conjures up an image of a nearly vertical short run supply curve.

But I don't think that's the same thing as your claim, "Raising property taxes won't change the physical number of apartment buildings available for rent."

Consider two examples to see what I mean:

(1) If the government in India proposed taxing cigarettes by 1 penny more, I don't think that would significantly affect the price of Pepsi in California. The supply and demand curves in California wouldn't move, so the price would stay the same for Pepsi, even though these curves are very ELASTIC.

(2) If the state government of California imposed a 50% surcharge on rental income from real estate, this would definitely reduce the "supply" of rental units (and raise rents for tenants) even though the physical buildings would still be standing there. Landlords would be pickier in their choice of tenants, and would leave more rooms vacant for storing their stuff, or for letting out of town guests stay there for free.

Do you see what I'm saying?

ThomasH writes:

Sounds good for short term effects although it may depend on costless knowledge by buyers and sellers of the relevant supply and demand curves. In a costly information model, incumbent suppliers might take the tax as new information about a fall in supply that they would use to re-set their profit mazimizing rent.

Rob Rawlings writes:

The increased property tax will cause profits on renting to fall in the short term as costs rise but rents stay the same. This will cause business people to move out of house renting into other lines until margins adjust.

I can see 2 effects:

- Supply of rental property decreases as supply falls
- Property prices fall so that rental margins increase.

The first effect will cause there to be tendency for rents to rise. Perhaps if your city is surrounded by cities with similar rental markets elasticities of demand may limit the level of these rent increases and cause the adjustment to mainly take place through property prices adjustments.

Mark Rand writes:

I am somewhat puzzled:

This blog seems to be aimed at non-economists who wish to learn, i.e., people who aren't necessarily economically literate.

This particular post is tagged as "economic education."

Despite this, Professor Henderson won't deign to respond to several reasonable comments above because he doesn't "know [that the individual who made the comment is] ... economically literate." The comments weren't rude (unless mine was inadvertently rude -- I hope it was not, and I apologize if it was), they weren't off-topic, and at a minimum they didn't display any gross misconceptions.

Regarding the original post's topic: in addition to the factors I mentioned in my first post, I would like to point out that one would expect a property tax to immediately increase the demand for rental units (assuming no increase in rents) as the cost of purchasing a home increases. Assuming supply of rental units remains constant, rents increase. (Renting is sometimes a substitute for buying.)

Over the past 30 years I've run several different businesses. In every one, I've increased my prices whenever my costs have gone up, although I cannot think of a case in which the market's supply of the relevant product has decreased and demand for my products has in each case been highly elastic (unlike demand for housing, which is surely fairly inelastic).

I have several friends and one sibling who own rental units. They've confirmed that when their expenses increase they'd increase the rents they charge. As one put it, "It's either raise the rent and hope it works, or get rid of the unit."

Glen Smith writes:

You forgot the cost of changing apartments and the strong possibility that the current renter can't change residents without significantly downgrading. Even now, most rental contracts have provisions for broken leases while month-to-month rates are significantly higher than contract rates. At most places, services can be cut back and at some places there is a lot of room to cut back those services before the residents get upset enough that they'll shoulder the moving costs. Of course, those moving costs include more than the costs of breaking the contract and hiring people to help (either by actually paying or calling in favors) but the time and effort involved, the social loss in some cases and the general disruption. Many rental properties require large deposits and/or payment of rent up-front that many who rent cannot afford without downgrading to an untenable situation. All these allow the landlord to increase the rent.

Tim writes:

@glen smith

The whole point of rental contracts is to lock in a rate. No lease agreement that I have ever seen allows the owner to raise the rent during the tenure of the lease.

I've seen situations where the end of a one year agreement went month-to-month after that, and at that point the landlord could raise the rent, however the renter could also move without a loss, provided they gave sufficient notice.

Now you did mention that moving has its expenses, and this definitely would allow some leeway for small rent increases. If my rent goes up by $25/month, I probably won't find the ~$400 cost of moving to be worthwhile. However, if the rent is going up by $100, I would definitely see if I couldn't find something with a more desirable combination of price and amenities.

Rob Rawlings writes:

Isn't it really as simple as this in terms of short term effects ?

- The property tax will reduce the margins on renting.
- This will deters some landlords.
- This will reduce supply.
- Rents will rise.

happyjuggler0 writes:

If producer costs rise universally in a rental (or other) market, you should also expect to see consumer costs also rise because in order to induce new units to come online and sending consumer rents down again, there has to be higher profit margins than there used to be for landlords.

There are no such increased profit margins in the example David Henderson seems to describe.

A similar example is across the board rising gasoline costs for gas station owners. They pass on the new costs to consumers and have the price stick because all of their competitors also face the same rising cost. There is no free lunch to be had for a new competitor coming into the market with lower retail gasoline prices if he faces the same producer costs as his competitors.

If on the other hand, a landlord decides out the blue to raise the rents on his properties without any sense that demand is increasing, or without any increases in industry costs, then he will likely find himself with a bunch of vacancies he is unable to fill at the new higher consumer cost.

David R. Henderson writes:

@Bob Murphy,
No, I don't get your point with (1) at all.
With (2), notice that you had the tax be a tax on rental income rather than a tax on property. This measure was about a property tax increase, based on assessed value, whether or not the property is rented.

David R. Henderson writes:

@Mark Rand,
I apologize. I was in a hurry and had to choose one to respond to. Because I know Troy, I chose his, hoping that I could get him to rethink it.
Before going on, though, let me suggest that you read my comment in reply to Murphy. Does that help? If not, say so, and I'll either comment later or do a new blog post.

Mark Rand writes:

@David Henderson,

Thank you for the new response.

Your reply to Bob Murphy is clear but as far as I can see completely unrelated to my comment.

Do you maintain that the proposed/defeated tax was so small that it couldn't possibly push any landlords over their break-even point? I've run too many businesses at near-zero margins (and know too many landlords who barely cover their mortgage payments) to find that plausible. And once a landlord or two is driven out of business (since you've ruled out increasing the rent), either supply goes down or the new owner will face the same problem. Furthermore, as happyjuggler0 notes, all the suppliers are facing the same increased expenses, which makes it easier for them to raise their rent.

I look forward to your explanation.

Mark V Anderson writes:

David --

I think you have proven here that we shouldn't always follow the expert. You are clearly an expert in economics, but I am positive you are also wrong here.

Mark Rand's first posting was a very cogent response to your posting, and he made more sense than you did. Maybe you should read it again. As Mike implies, it is usually the supplier at the margin that will lead to changes in supply, and he gave examples of how this might occur. As he said, perhaps there are no landlords on the margin and so no changes in supply, but that is an empirical question. Perhaps your reply would be that someone else would buy the housing even if the marginal landlord can't cut it, but that doesn't take into account changing some of the housing to owner occupied.

And the long run change in the equilibrium is even clearer. The cost to landlords will definitely have an effect on how many landlords enter and exit the market, and also the rents they would be willing to accept would change based on the costs incurred. How could rents not increase if the higher costs make some apartments not worth keeping up and so are abandoned.

Even beyond that, the value of the properties to the tenant will likely decrease. Even if the landlord can't unload his properties, he will try to make a profit by cutting back on repairs and such. lowering the value to tenants.

David R. Henderson writes:

@Mark V Anderson,
but that doesn't take into account changing some of the housing to owner occupied.
The added tax would give no reason to change to owner-occupied. See my reply to Bob Murphy.
And the long run change in the equilibrium is even clearer. The cost to landlords will definitely have an effect on how many landlords enter and exit the market, and also the rents they would be willing to accept would change based on the costs incurred. How could rents not increase if the higher costs make some apartments not worth keeping up and so are abandoned.
All true. And it's a point I made in my post.

happyjuggler0 writes:

David Henderson,

I still think that you are missing an obvious point (or I am!) regarding industry-wide producer cost increases. So I will backtrack a little and explain my mental model of what makes a rental market settle at a given equilibrium.

Most markets of any kind that are 1)stable 2)competitive 3)open-access to new producers, have a nominal producer profit. If profit margins go up due to new demand, then new supply will soon follow, pushing consumer prices back to the old equilibrium.

At the same time, most markets that fit those three conditions also operate such that most such consumers would be perfectly willing and able to pay more, but they don't have to because they enjoy consumer surplus due to the three conditions I outlined last paragraph.

A property tax increase increases the costs of the rental unit owners, thereby decreasing the profit margin for those property owners to below the previous market equilibrium.

Given a lower operating margin for all such producers, why wouldn't any or all of them simply increase their rents to compensate for most (perhaps a smidgen less) of the new industry-wide cost increases (i.e. property tax increases)?

A typical economist response *might* be that they were already charging what the market (i.e. the consumer) would bear, but this seems wrong because of the aforementioned consumer surplus on the one hand, and the new below equilibrium rate of return on employed savings (i.e. investment returns) that came about when the property tax increase hit.

To make a long story short, a rent increase that restored the previous rate of return on capital would not induce new supply to come online. At the same time, due to the previous consumer surplus, the bulk of the tax increase can indeed be passed on to renters because they can afford it combined with the fact that no new supply will be coming online for them to move into.

David R. Henderson writes:

@happyjuggler0,
Here's the key part of your argument. If you were right here, what you say would follow. But you're wrong. You write:
Given a lower operating margin for all such producers, why wouldn't any or all of them simply increase their rents to compensate for most (perhaps a smidgen less) of the new industry-wide cost increases (i.e. property tax increases)?
Because--and this is the point of my post--the only way that would happen is if supply shifts. Supply will shift in the long run but not the short run because the amount of rental housing--especially in Pacific Grove, where it's hard to get permission to build anything--is fixed in the short run.
Whenever you find yourself reasoning from "they will increase prices," stop. Then ask yourself: "Did supply shift or demand shift?" If not, then prices won't change.

happyjuggler0 writes:

Ok, now I am still unclear which one of us is confused.

I am reasoning from the point of view of can an immediate price increase stick (both short term and long term), and you seem to be arguing that they wouldn't increase prices until housing units started disappearing (I could be wrong as to what that is you are arguing).

They can raise the price of what they charge (excepting under rent control, but that is another animal). The issue is whether or not it will stick (i.e. will they get someone to sign a lease at that new higher price).

Why wouldn't the price increase stick? I don't see where permission to build (or lack thereof) undercuts the ability of landlords to make a price increase stick, indeed it seems to strengthen their ability to do so.

If it would stick, why wouldn't landlords indeed increase their rental price ASAP?


BC writes:

David, your analysis assumes that the demand curve for rental housing is unaffected by the tax hike, and I think that is incorrect. I believe Brian has it right. Demand is impacted by substitutes, and owner occupied housing is a substitute for rental housing. A property tax hike increases the cost of owner occupied housing, leading to an outward shift of the demand curve for rental housing (substitution effect). In turn, an outward shift of rental housing demand leads to a combination of higher rents and more rental housing. In the short run, if one assumes that rental housing supply curve is vertical, then all of the effect will be in higher rents.

Another way to say the same thing is that there needs to be an equilibrium between owner occupied and rental housing. Consider a huge tax increase that dramatically increases the cost of owner occupied housing. It's implausible that equilibrium between rental and owner occupied housing could be maintained without some change in rental housing. Rents would increase and/or (in the long run) more rental housing would be constructed in place of owner occupied housing. The result is a combination of higher rents and more rental housing.

I think this is definitely a case of statutory incidence of the tax hike being on property owners but economic incidence being on everyone.

BC writes:

Upon further thought, a property tax hike might also shift the supply curve up and to the left in the long run. Real estate investors in the long run can shift investment from rental housing to non-real estate investments. Since a property tax hike increases their costs, they will need higher rents to entice them to invest in rental housing. So, both the demand substitution effect and the supply curve shift increase rents. The impact on rental housing quantity is ambiguous (as far as I can tell).

Rob Rawlings writes:

"Supply will shift in the long run but not the short run because the amount of rental housing--especially in Pacific Grove, where it's hard to get permission to build anything--is fixed in the short run."

If property taxes increase then even in the short term landlords can sell their properties because they don't like the new lower margins. Logically, rents will rise.

Radford Neal writes:

BC writes: "Consider a huge tax increase that dramatically increases the cost of owner occupied housing."

But does it actually increase the cost? Consider a renter considering buying a house. Surely, with the tax increase, they will be able to buy the house for less (paying correspondingly less in mortage payments, if they are borrowing to buy).

I think one can consider a property tax increase as a partial expropriation (without compensation) from the owners of property. The higher tax means they can sell their property only at a lower price. The old owner loses (assuming the tax increase wasn't fully anticipated before they purchased the property), but it's not clear that a new owner is any worse off.

Ak Mike writes:

What a great interchange! I enjoy these little puzzles.

Actually, everyone is wrong, even our host Dr. Henderson. Rents will decline. Why? Because supply will increase. Why? Because of a fact everyone is ignoring: this is a real estate tax, not a tax on rentals. The tax will have to be paid whether a particular rental unit is in service or not.

Therefore, property owners will have greater carrying costs for their property, and will be more motivated to spend money to put marginal units into service. Faced with, say, a $5,000/year tax increase, they will spend $5,000 to buy new appliances for that broken down unrented unit. They will clear out that basement unit they had been storing junk in. Etc. More units in service means greater supply, which (in the absence of some factor increasing demand, which I don't see here) means a decline in rents.

John B writes:

The main factor for short term rent rates is what provisions there are in the contract for rent increases.

Landlords can either put rents up or they cannot irrespective of their increased costs or supply and demand.

In considering competition, there are wide differences in rates anyway determined by location, facilites, size, desirability and factors personal to the putative leasee.

There is no direct comparison for many rental properties, so rent comparisons can be difficult. Rents anyway for similar properties tend to be in a range, say 600 to 700 per period.

Increasing a rent from 620 to 640, say, would not deter tenants.

There is also inertia. Would a modest rent increase cause a tenant to move?

What about new rentals which have factored in the new taxes?

The supply/demand argument works if inertia, mobility, Human factors are ignored.

Economist live in world where logic rules; Humans don't.

In the real World, when costs go up, prices folllow.

Tom E. Snyder writes:

I had a problem with David's post at first but I think I now see the point. Holding rentals off the market would not eliminate the tax since it is a property tax. You pay the tax whether the unit is rented or not. The only way to avoid the tax is to sell the property. If it were an occupancy tax on units rented it would have some effect on supply.

You could reduce the tax by destroying the property to get a lower assessment but who does that?

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