In a digital economy, how can cities create a more equitable property tax system?
By Fritz Kaegi
About this essay:
The Chicago Council on Global Affairs is an independent, nonpartisan organization that provides insight on critical global issues, advances policy solutions, and fosters dialogue about what is happening in the world and why it matters to people in Chicago, the United States, and around the globe.
The Council asked Assessor Fritz Kaegi to submit an essay to its recent collection “Reclaiming the Right to the City,” wherein “a diverse set of experts examine the question of rights in, and to, the city in a wide and exciting array of geographies and contexts…They highlight powerful inequities and contradictions in city life and also offer policy solutions.”
His essay is reprinted here with kind permission. For more on the CCOGA’s “Right to the City” project, visit its website.
Cities around the world are evolving as digital technology and the global pandemic alter the urban economy. But how can the funding sources for city services like education evolve with them? Without a 21st-century system of property taxation that supports equitable funding for all, cities are likely to generate pockets of de facto segregation along racial and economic lines. Giving everyone the right to the city for all requires revenue-model innovations that match the leaps and bounds we’re making in technology. With a global economy reaching into even the smallest of towns, we must look beyond the traditional borders of local governance to lift all as cities undergo economic transformations.
The funding tools available to cities are ever more ill-suited to fair taxation. In the United States, the fiscal mechanisms for schools, municipalities, and other units of local government lean heavily on taxing property (more than half of local revenues if state and federal aid is excluded). Illinois has the third-highest number of school systems in the nation (behind California and Texas), and the majority of public education funding in the state (63 percent) is derived from property taxes. Funding for education relies on real property, yet this spatially rooted “tax base” is under threat as economic activity becomes increasingly digital, with no fixed location and much less dependence of brick-and-mortar assets. In 1990, information technology companies and direct retailers accounted for only 4 percent of the market capitalization of the S&P 500 Index, a widely accepted proxy for the US stock market; in 2021, these companies account for 32 percent of the index. Moreover, the five largest companies in this sector — Apple, Microsoft, Alphabet/Google, Amazon, and Facebook — now account for 20 percent of the earnings before interest, taxes, and depreciation of all the companies in the index, according to data from Bloomberg. The global pandemic greatly accelerated this trend, as office workers moved to Zoom, retail sales shifted to Amazon and Grubhub, and families decamped to more remote locations.
Why brick and mortar taxation hurts equity
Tethering the funding of local services to brick-and-mortar assets is troubling from the point of view of equity and the question of who has the right to the city, because the digital portion of the economy is not similarly taxed. Without additional revenue sources, communities will have to sustain themselves on the taxes derived from the value of local property. Essential services decline, new potential residents look elsewhere, job opportunities fall off, and an already declining tax base suffers further. Freedom of movement will only be possible for those who already enjoy economic prosperity.
Make no mistake: small businesses and brick-and-mortar spaces are still at the heart of community vitality and sustainability and will continue to be important. They give communities and cities their distinctive character and special sense of place, not to mention employment. But why should capital invested in these city-sustaining activities be required to cover so much of the cost of local services, while the growing share of the digital economy gets a pass?
Using property taxes to fund services such as education can also reinforce segregation and unequal outcomes, because tax revenues vary from one district to another based on the size and prosperity of the local real estate tax base. For example, communities in Illinois with more affluent property owners and an abundance of businesses can afford to spend more per pupil on education, while communities with fewer resources struggle. This system not only reinforces segregation and existing disparities but also further widens the wealth gap. Illinois ranks last in the United States for state sharing of revenues with school districts. As a result, property taxes are generally high, largely to fill this gap. The lower the value of real estate in a community, the higher the effective rate to provide a comparable level of school services. This results in great disparities.
Who is hurt the most by high property tax rates
In my jurisdiction of Cook County, for example, the communities with the 20 highest property tax rates exceed the other 110 communities by three to five times, even though the level of education funding per pupil is comparable or less. (See the chart below.) Most of these communities are majority Black, while most of the other Cook County communities are majority white. For communities at the top end of rates, taxes exceed 5 percent of home values versus the effective average in Chicago of under 2 percent. In the assessment universe, this is called “regressivity”: when property owners with more modest homes and businesses have to pay more of their share than more affluent property owners.
First, for a dollar invested in housing, higher property-tax rates can overwhelm the beneficial effect of compound growth in asset prices. Much like a ruinously high management fee on a mutual fund versus the low fee of an index fund, this puts a lid on prices and can in fact push them down, depressing intergenerational wealth.
Second, less-wealthy individuals and minorities tend to have more of their wealth invested in homes that are burdened by high taxes, while wealthier households have more of their savings invested in financial and business assets that are not subject to similarly heavy annual taxation. According to the US Federal Reserve Bank, in 2021 the bottom half of US households by wealth had about 50 percent of their wealth invested in real estate, while the top 10 percent of households by wealth had just 19 percent of their wealth in real estate. Black and Latino Americans also had more of their wealth invested in their homes than other racial groups. In the United States, homeownership has been one of the fastest ways to build wealth, because families can leverage it through mortgage debt. This is even more important for Black families, who possess about one-tenth the wealth of whites and who typically hold the majority of their wealth in their homes. Property taxes can eat away at the appreciation of these assets, which slows wealth creation, or worse, subtracts from it, leaving these families further behind and potentially under water on their mortgages. Legal scholar Dorothy Brown’s book The Whiteness of Wealth: How the Tax System Impoverishes Black Americans and How We Can Fix It describes the myriad ways our tax system is structurally designed to advantage white taxpayers while disadvantaging Black households.
By mapping this web of taxation policies and practices onto physical space, one can see how these structural rate disparities exacerbate inequality. They serve as a hidden road map guiding investment, property values, and resources for education and other services across neighborhoods. Capital that can be invested in real estate converges toward areas with the lowest real-estate taxes, unless the capital can earn a compensating additional return in areas where effective property-tax rates are higher. The main mechanism for providing the compensating additional return is lower real estate prices, which further shrink the local tax base. Capital flows to the affluent areas with the most expansive base of property values. The areas with the narrowest base of property values, meanwhile, experience downward pressure on prices to provide investors with additional return to compensate for higher and potentially growing property tax rates. Thus economic segregation builds on itself. Data increasingly show that the COVID-19 pandemic, with its associated accelerated changes in technology and behavior, has turbocharged this inequality.
Local solutions for more a equitable tax system
While my office does not have jurisdiction over municipal tax levies, I can say that increased federal and state support for school funding will help reduce the tax burden paid by homeowners and local mom-and-pop businesses while also reducing racial disparities in schools and community services. As noted, Illinois provides the lowest level of funding for education of any state in the nation. An increase in federal school funding through Title I of the 1965 Elementary and Secondary Education Act, is the most direct way to decrease property taxes and geographic inequality while investing in education. If we doubled the current $300 million in Title I funding for Chicago’s public schools and passed on the savings to ratepayers, the property tax levy for schools could be reduced by 10 percent.
We must reimagine and reprioritize how we fund education by increasing federal support. This is not a new or radical concept. It was so important to civil rights and labor leader A. Philip Randolph that he included it in his speech at the March on Washington in 1963, saying “We want integrated public schools, but that means we also want federal aid to education, all forms of education.” If we agree that everyone has a right to the city and that dismantling inequality is imperative, we must continue to push for local-school funding that is not rooted in local land values — especially as more business moves online — so that everyone has access to quality housing and vibrant communities without disproportionately burdening the property owners we seek to help.
Furthermore, as digital technology and the pandemic further uncouple economic activity from physical property, taxation that focuses on the income generated — rather than on the assets that can generate it — becomes ever more vital, especially for cities. In the status quo, taxation favors income generated from asset-light strategies, while heaping most of the costs of local services on the shrinking share of economic activity generated by those who own and invest in physical assets. The more digital an economy gets, the more unfair the distribution of costs becomes if property tax is a principal source of revenues. Taxing income generated, regardless of how physical assets are employed in generating the income, more fairly distributes the costs of investing in education and government services and does not discriminate against the kinds of commercial and residential activities that make cities thrive.
Once we understand this principle, the next question becomes: Who is best placed to tax income? One characteristic of the digital economy is that it may be difficult or impossible to attribute a physical presence to the various participants in the economic activity. Moreover, doing so may introduce incentives to shift profits to areas where income evades taxation. This is especially true when viewed from the perspective of a city, where activity can cross boundaries easily and even painlessly.
How states and the federal government can help
What about state or provincial support? A state or province may have drastically different interests or incentives vis-à-vis the city and may not want to put the taxation of income on an equal footing statewide and at a level sufficient for cities to fund education and government services. Moreover, just as transfer pricing strategies can shift incomes and profits away from cities to places where they are not taxed, this dynamic also prevails between states and provinces. Depending on state or provincial support may further inequities by punishing residents of cities where states or provinces are hostile to them.
As economies become more digital, it will become increasingly clear that cities and states cannot solve these problems alone. The nation — which means the federal government in the United States — is best situated to tax incomes generated by activity like digital commerce, virtual meetings, and footloose service providers. Nations will need to build fiscal mechanisms for a digital world that separates economic activity from physical space. Nations should likewise feel the pressure to increase their co-investment with cities in wealth- and equity-building activities like education, which after all prepares the nation’s people for citizenship and economic competitiveness in a digital, globalizing economy. In the United States, Title I provides a ready mechanism to do so. After many years of stasis in funding, Title I has come back into focus with the Biden Administration’s commitment to significantly step up this funding.
Though it is fair and desirable for the nation to use the fiscal tools uniquely at its disposal to invest in education and certain other local services that benefit the nation as a whole, the next challenge for the city will be negotiating autonomy. If education and other areas get more support from the national government, more strings may be attached — perhaps in the form of required curricula or standardized testing. National authorities’ policy goals may be at odds with the attitudes and goals of those in the city. The number and nature of attached strings will spark debates about topics that previously took place at a local level.
As the saying goes, the best government is the one closest to the people. This principle has been inconsistently applied in the United States — it is arguably more honored in the breach than in the observance — but advocates for cities may find themselves making just this argument, especially in huge, diverse countries such as the United States. If a digital economy puts more of an emphasis on national fiscal mechanisms, cities around the world will face new challenges in negotiating autonomy vis-à-vis national governments. The debate over who owns the city will be coming to national political conversations around the world.
