Wealth and Property Taxes

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Wealth and Property Taxes

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois

Econ 214
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Topics for today

• History of wealth taxes
• Why tax wealth?
• The property tax -- who bears the burden and why
  is it so unpopular?
• Estate and gift taxes -- the taxes everybody
  tries to avoid

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History of wealth taxes

• Bequest taxes in the time of the Roman Emperor
  Caracalla
• The first property tax under William the
  Conqueror
• Property taxes in US colonial times
• US Estate tax dates to 1916

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Measuring wealth

• Wealth is a stock income is a flow
• Income is the return on wealthIncome interest
  rate x wealth
• Wealth is the capitalized value of incomeWealth
  Income / interest rate
• Wealth is the sum of
• physical capital
• Real property (land and improvements) yields
  rent
• Tangible personal property (moveable assets)
  yields rent
• Intangible personal property (stocks, bonds,
  cash) yields interest, dividends, capital
  gains
• human capital (yields wage income)

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Problem 1
Suppose an acre of farmland is expected to
generate 150 net of expenses and taxes each year
in perpetuity. If the discount rate is 5, what
is the value of the acre of land?
ANS 3,000 150/.05
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Should wealth be taxed?

• A wealth tax may be needed to compensate for the
  failure of the income tax to tax all forms of
  income (particularly unrealized capital gains).
• A wealth tax may be needed to reduce large
  concentrations of wealth.
• A wealth tax may be a way of taxing the biggest
  beneficiaries of government (i.e.,
  wealth-holders).

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Effect on saving and work
A wealth tax reduces saving and investment (if
saving is interest elastic), but does not impact
labor supply.
D
Interest rate
S
D-t
S0
S1
Saving, Investment
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Main forms of wealth tax

• Property tax (tax on real estate collected by
  local government)
• Estate and gift tax (tax on the transfer of
  property at death or gift collected mainly by
  the federal government)

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Property tax

• Local tax on the assessed value of property
  within the jurisdiction
• Illinois is a high property tax state
• The property tax is the main source of school
  finance in Illinois. Results in different
  spending levels across districts.

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Property tax base

• Consists of the assessed value of real property
  (land and improvements) real estate
• Does not account for claims against the property
  (mortgages)
• Property owned by religious and charitable
  institutions (churches, U of I) excluded from tax

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Assessment of the property tax

• Assessment is the valuation of taxable wealth
  (real estate)
• Ideally, the assessed value of an asset should
  reflect is current market value, but this is
  difficult to determine for infrequently traded
  assets
• Illinois (and most other states) practice
  fractionalized assessment whereby property is
  assessed at a fraction (33 in Il) of its
  purported market value.

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Tax capitalization

• The decrease in the value of a taxed asset equal
  to the discounted present value of future tax
  liability of its owners.
• Value before taxV Y/r
• Value after taxVt (Y-tVt)/r or Vt Y/(rt)
• The property tax burdens the present owner of an
  asset, but frees future owners from its burden!

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Example close to home
Property tax rate per 100 of assessed valuation
URBANA
CHAMPAIGN
7.8079
8.9249
Approximate tax on 100,000 house
2,945
2,577
In the long run, people will move to Champaign
and the value of the house in Urbana will fall by
around 7,360, the capitalized value of the tax
differential (2,945 - 2,577)/5
7,360
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Who bears the property tax burden?
In the long-run, property tax differentials will
likely be capitalized into the value of the
property.
Full tax capitalization puts the full burden of
the property tax on holders of property at the
time of tax increase.
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What about renters?
Rent
S
rg
r
D
rn
D-t
H1
H2
Rental housing
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Not a popular tax

• Difficult to administer
• Fractionalized assessment and equalization
  attempt to correct assessment errors but are
  confusing
• Causes a cash-flow problem for elderly and
  farmers
• Provides an independent source of revenue for
  local governments

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Discussion

• Who would benefit and who would lose if Illinois
  were to reduce its property tax?

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Estate and gift taxes

• Federal taxes on the transfer of property through
  gift or bequest that raise less than 2 of
  federal tax revenue
• Compensate for the failure to tax inheritances
  and gifts in the personal income tax
• Contribute to reducing overall inequality in the
  distribution of wealth and income
• Encourage charitable contributions

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Features of the estate and gift taxes

• Each estate is allowed a lifetime exemption of
  650,000 (in 1999 1 million in 2006)
• Transfers to spouses are not taxed
• Each individual may give tax free each year
  10,000 to an many beneficiaries as he or she
  chooses
• Rates range from 18 on the first 10,000 to 55
  on more than 3 million
• Charitable bequests are fully deductible

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Avoiding the estate tax
Lifetime gifts can shelter substantial estates
from taxation. A simple example A husband and
wife expecting to live twenty years jointly give
each of their three children 20,000 per year.
Over the twenty year period, they can shelter
1,200,000 (20,000 x 3 x 20) from the estate tax.
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Avoiding the estate tax
Trusts are widely used by wealthy individuals to
avoid the estate tax. A simple example A 1.3
million estate can escape estate taxation if each
spouse sets up a 650,000 trust to provide income
to the surviving spouse while he/she lives and to
vest to the children at the spouses death. The
650,000 lifetime exemption protects each estate
from taxation.
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Problem 2
You and your spouse expect to live ten years.
You have two children and three grandchildren.
How much of your estate could you protect from
estate taxation by making lifetime gifts and
setting up trusts? What could you do to protect
your children from the estate tax?
ANS (I think) 2.3 million 1.3 million by
setting up trusts to take advantage of the
lifetime exemptions and by making lifetime gifts
of 100,000 per year.
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Other ways to avoid the estate tax

• Charitable trusts and foundations charitable
  contributions are exempt from the estate tax
• Life insurance can be signed over to your
  beneficiaries together with an annual gift to pay
  the premiums

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Guess who said ..
"The parent who leaves the son enormous wealth
generally deadens the talents and energies of the
son, and tempts him to lead a less useful and
less worthy life than he otherwise would."
Andrew Carnegie
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Effects on saving

• Younger generation -- estate and gift tax
  encourage greater industriousness (income effect)
• Older generation -- estate and gift tax reduce
  the reward saving leading to a reduction in
  saving (substitution effect). However, the tax
  might also have an income effect leading to more
  saving given a desire to leave a given amount to
  heirs.

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Not a popular tax

• The tax collects little revenue
• Resources are wasted on estate tax avoidance
• The estate tax causes a cash flow problem for
  some estates, particularly farms and small
  businesses
• The tax encourages charitable contributions and
  reduces the concentration of great wealth

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Soap Box
Should the estate tax be abolished? Give a good
economic argument pro or con.
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Next time
Tuesday Dec 5 Governor Edgar (Come prepared
with some questions) Thursday Dec 7 Review for
the final and course evaluation Tuesday December
12 Final Exam 130-430 pm 130 Wohlers Hall