Wells Fargo On The Next Shoe To Drop For Local Governments -- Declining Property Values

A sub-debate withing the broader muni debate is the question of whether local government finances are in deep trouble thanks to laggy property price revenue. To put it another way: Because property prices aren’t assessed in real time, there’s fear that in coming years, cities will feel the brunt of the big house price collapse we’ve seen across the country.

Here’s Wells Fargo’s take:

One important distinction between state and local governments is the difference in their funding sources. State governments typically rely on a diverse mix of revenue sources that allow the state to better cope with cyclical revenue declines. Local governments, on the other hand, often rely heavily on three main sources of income: appropriations of general revenue from the state, local property tax revenues and local sales tax and fee revenues. Consumption-based revenues have been particularly hard-hit during this recession. In addition, state governments in many cases have reduced the amount of funding they have appropriated for local governments or delayed payments to them. The result is that local governments have been forced to take drastic steps to repair their budgets.

One revenue stream of concern for local governments is property tax revenue. Across the United States, 24.3 per cent of local revenue was derived from property taxes in 2008. Despite sharp declines in house prices in many parts of the country, local governments should only see modest declines in property tax revenues as the collection process and changes to tax rates over the course of the past two years will limit declines.

property prices

Photo: Wells Fargo

property prices

Photo: Wells Fargo

But it’s not all bad news. For one thing, revenue in many areas weren’t hiked during the boom as much as you might think.

The assessment and collection process for property taxes creates considerable lags between changes in property market prices and changes in revenues. Assessment values typically lag market values by five years. The discrepancy between current prices and current revenues is further widened by the collection cycle, where revenues are collected for the prior year’s assessment. As a result, property taxes do not initially decline with house prices, softening the hit to government budgets as other revenue sources decline. In addition, many states have limits as to the amount property taxes can increase in a year. California, for example, limits the amount property taxes can increase by two per cent or the rate of inflation, whichever is less. As such, homeowners may see a decline in the assessed value of their home, but still owe more taxes than the previous year. Furthermore, during the early part of the recession in late 2007, many local governments began to feel the effects of revenue declines. As a result, they increased property tax rates to offset losses.

In conclusion, you can add them to the list folks who disagree with Meredith Whitney:

The recent tax increases combined with the cyclical nature of property tax collection should moderate the decline in property tax revenues, as evidenced by a recent paper by Lutz, Molloy and Shen. The authors also found that during previous periods of home value declines, many of the same factors – lags in the collection process and increased tax rates – helped property tax revenue remain fairly stable during these time periods. In states that do experience moderate declines in property tax revenues, given the lags in the assessment and collections process, the declines will likely not occur until other revenue sources have recovered. Thus, we do not believe that there will be substantial declines in local property tax revenues. Most of the revenue declines observed at the local level will likely be isolated to reduced sales and use tax collections along with state appropriations to these local governments. We therefore we do not believe that substantial numbers of municipal government defaults are likely to occur over the next year.

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