The Real Reason We Don’t Build in Palo Alto (or Any High Cost Part of California)

Palo Alto has not had a good few weeks. First, Kate Vershov Downing wrote an open letter of resignation to the Planning and Transportation Commission because she and her husband could no longer afford to live in the city. Then, Mayor Patrick Burt struck back in an interview, saying that Ms. Downing’s idea of a starter home was unrealistic and confessing that he’d like fewer jobs in the area, as a way to slow down spiraling housing costs. Just in case it isn’t abundantly clear by now, this is not normal behavior.

The battle here is over the spiraling cost of living in formerly middle class Palo Alto, a city that’s home to the best school district in the state, and offers easy access to high paying technology jobs, has plentiful public spaces, and fantastic weather. Together with a reasonably priced starter home, this high quality of life embodied what historian Kevin Starr called “the California Dream,” something which could be had in cities up and down the Golden State in the mid-20th century. But as good jobs and good schools became less plentiful in California, more people have gravitated towards the few communities that can still promise a short commute, solid compensation, and quality education (or, at least, the beach).* Unfortunately, these communities have done all they can to throw up what amounts to “No Vacancy” signs, using land-use regulations that were passed decades ago during times of rapid expansion to limit as much growth as possible.

And here’s where we get back to Palo Alto. Ms. Downing — like so many who have written about the California’s housing crisis — pins the blame for the abuse of land-use regulations in the city on those serving on the City Council and the Planning and Transportation Commission, but their NIMBYism is just a symptom of a much more serious illness: California’s Proposition 13.

Proposition 13 was a ballot initiative passed by voters in 1978 that caps property taxes at 1% of the purchase price of a piece of property and only allows the tax to raise up to 2% each year thereafter. At the time of its passage, property taxes were skyrocketing, as a result of high inflation and some homeowners — especially those on fixed incomes — were being forced out of their homes. The proposition immediately put a stop to the rate hikes, rolling back and freezing assessed values at the 1976 levels, and only allowing reassessment when the property changed hands.

But the one large positive effect of the proposition — people were able to keep their property and stay in their homes — didn’t offset the myriad negative effects. To make up for massive, sudden budget shortfalls, the state had to step in and begin funding local services — a practice that continues today — centralizing control in Sacramento. The state also saw a major hit to their own revenue stream, requiring the budget to rely heavily on state income taxes, which fluctuate wildly depending upon the performance of the economy. As California Senator Dianne Feinstein put it in 2010, “In most states, it’s one-third property tax, one-third sales tax and one-third income tax. It’s 55 percent income tax in California.” Any examination of California’s perpetual budget crisis must start there.

But, what does all of that have to do with NIMBYs and land-use in Palo Alto? Everything. Because Proposition 13 does not allow for property value reassessment, any windfall from a spike in property values is captured completely by owners. This creates an incentive for owners to keep property in their area expensive — after all, they don’t pay anything extra — and the best way to do that is to constrict supply as much as possible. Check out the graph below from the California Legislative Analyst’s Office:

Notice that even when the market is at its peak, in 2007, the property is still only being taxed at about $325,000. And here’s how the effective tax rates break out:

As soon as the property gains value, the effective tax rate drops below 1%, and the longer you own the home, the better the deal. Places near job centers, like the San Francisco Bay Area, or near the coast, have benefitted the most from Proposition 13 and it’s no coincidence that those are the same places where land-use regulations are particularly stringent.

NIMBYism is able to take hold in places like Palo Alto because more development provides absolutely no benefit to incumbent property owners in a system where property taxes don’t change. More people only means more traffic, busier parks, and more crowded schools. Even worse, if property values are driven down by enough development, it’s tantamount to a redistribution of wealth — it’s better to just not build anything at all.

A California without Proposition 13 would still face hurdles to development, and the abuse of land-use regulations — no one likes crowded parks or traffic — but to a much lesser extent. Imagine if the proposition had never passed but everything else remained the same, residents that bought $100,000 homes in Palo Alto in the 1980s would have seen their property taxes skyrocket along with their property values, leaving them with two options: move to a lower cost area or push for measures that would make their own property less valuable. Considering all of the benefits of living there — schools, jobs, weather, “the California Dream,” etc. — it’s reasonable to think that Palo Altans would have pushed for at least slightly more development over time. If that had happened in all high cost areas across the state over the last nearly forty years, even on a small scale, things would not be nearly as dire as they are today.

The real reason why we don’t build more in expensive parts of California is Proposition 13. Sadly, the proposition is enshrined in the California Constitution, with no chance of being repealed without a state constitutional convention. As long as that is the case, a serious lack of development in high cost areas like Palo Alto is here to stay. We should get used to Kate Vershov Downing’s, we’ll be hearing from a lot more of them.

*Yes, this is a dramatic oversimplification, but explaining migration patterns would require a much longer — or a whole different — post.