Why Texas Has Cheap Housing

Hint -- it's probably not for the reason you might think, namely, that Texas has generally freer markets than other states.

I have just finished Murray Rothbard's behemoth Man, Economy and State.  It was a very difficult but rewarding book -- it took me six months to finish -- and I'll have plenty to say about it in the near future, but for now I thought I'd just share one little insight it has given me.

In the section on taxation in Power and Markets, he discusses the different effects of taxation on market behavior, especially as it relates to the actual incidence of taxation.  This is a subject that one commonly sees butchered in financial and political news, as politicians and commentators opine that increasing such-and-such a tax by some amount will increase revenues by so much and reduce deficits by this percent, or that the implementation of some tax will be a burden this or that group.  They are almost always basing their analysis on a static picture of the economy -- one that will be basically the same tomorrow as it is today, except with a new tax.

Anybody with two brain cells to rub together knows that a tax will change behavior within the economy, but even most people who realize this will have a difficult time working out in their minds just exactly how it all will play out in the end.  Rothbard attempts to do just this with a number of different types of taxes, and though I disagree with him on some of them (which you'll hear about in the future) nonetheless, I think he got them mostly right.

Of particular note were property taxes and a sort of 'net-worth' tax.  While income and sales taxes take a slice out of incomes in both cases (at least by his analysis), property and especially net-worth taxes are positively devastating to the economy.  The reason is that they tax the capital base in such a way as to radically change market valuations and discourage capital accumulation, which radically alters behavior and the potential for growth.

He provides a good example of a rent house.  Suppose a house is worth $100,000.  Further suppose that the natural rate of interest is 5%, which I take to be a fairly accurate estimate.

Now, the key to this analysis, as with practically the entire study of the free-market, is to recognize the tendency of competition to push every valuation towards equilibrium.  The natural rate of interest happens to be the return to capital which will theoretically be uniform throughout the economy because of the effects of competition.  Any investment opportunity which will afford a return above the natural rate will tend to attract investment by entrepreneurs, either pushing up its price, or introducing competition with it, such that the rate returns to the natural rate.  Likewise, any investment which affords a return below the natural rate will fall in price until the return comes to the natural rate.  This is most easily observed in the bond market.  A rise in interest rates will cause bond prices to fall, while a fall in rates will cause prices to rise, so that all rates throughout the market are roughly uniform (and neglecting dates of redemption and risk premiums/discounts).

Back to the example of the house.  After maintenance and insurance costs, the house is expected to return $5000 in income to its owner per year.  This is considered interest income on a capital investment, such that it is in competition with, say, a $100,000 bond, which would yield exactly the same income to the holder of the bond.  Now, suppose a local government slaps a 1% property tax on the house.  That $1000 must now be paid out of the $5000 income, such that the return from the house is now only $4000.

The house can no longer compete for investment dollars with the bond.  Its price falls.  How much?  To about $83,300.  This corresponds to a property tax of $833 per year and yields an income of $4165, or about 5%.  A 1% property tax knocked a whopping 17% off the market valuation of the house!

What is the rate here in Texas?  Where I live, it varies between about 2.7% and 2.9%!  Anyone still interested in Texas real estate?

I had always known that a property tax would tend to depress the value of a house, but I had no idea how much because I had no idea how to calculate it.  This operation had not occurred to me.  On the other hand, it is also true that the fall in the value of the house only occurs at the time the tax is levied, or if it is later raised.  Once it is in place, of course, existing houses become cheap, so if you are a buyer, you can get a 'good deal,' so long as one doesn't mind paying out that discount over time to the government.  (Think about it -- $833 corresponds to the interest on the value that the house fell, as if you'd taken out a permanent loan for the remainder of the original price of the house...)  So, it is the holder of the house at the time the tax is levied who absorbs the entirety of the loss.  Later owners are only paying the discounted value of the difference in valuation.

But there is another sort of loser in this game -- new homebuilders.  These people will have to be careful to keep the cost of building the house well below the free-market valuation of the house, because upon completion government will implicitly be seizing a sizable portion of this value for tax purposes.  If you are someone who would like to build a rather unusual house of higher quality than normal, such that costs are a bit more than normal, you must be prepared to eat a rather enormous loss well above and beyond your expenditures on materials.  As you can see, as time goes on, the tendency will be to produce ever cheaper -- and presumably lower quality -- housing due to the overwhelming pressure imposed by the tax.

Thus, if you buy a house in Texas, you can probably get one cheap.  But you'll probably be getting a cheap house.  Lots of people say that Texas is a great place for business, especially because of the absence of an income tax, but to the degree that the tax is shifted towards property, I'm not sure that this is necessarily a good trade-off.  Especially if 'property' includes commercial property, a.k.a. business capital, a.k.a. one of the more important sources of economic growth.