In the absence of comprehensive urban planning policies, property tax on real estate changes the incentives for developing land, which in turn affects land use patterns. One of the main concerns is whether or not it encourages urban sprawl.
The market value of undeveloped real estate reflects a property's current use as well as its development potential. As a city expands, relatively cheap and undeveloped lands (such as farms, ranches, private conservation parks, etc.) increase in value as neighboring areas are developed into retail, industrial, or residential units. This raises the land value, which increases the property tax that must be paid on agricultural land, but does not increase the amount of revenue per land area available to the owner. This, along with a higher sale price, increases the incentive to rent or sell agricultural land to developers. On the other hand, a property owner who develops a parcel must thereafter pay a higher tax, based on the value of the improvements. This makes the development less attractive than it would otherwise be. Overall, these effects result in lower density development, which tends to increase sprawl.
Attempts to reduce the impact of property taxes on sprawl include:
Most cities have a higher building tax than surrounding suburban and rural areas. By removing improvements as a factor in the property taxes, the penalty against construction and renovation in already urbanized areas is removed. Increasing the tax on land value discourages land speculation - which forces development further away from central cities - and encourages efficient land use.
Current-use valuation - This method assesses the value of a given property based only upon its current use. Much like land value taxation, this reduces the effect of city encroachment.
Conservation easements - The property owner adds a restriction to the property prohibiting future development. This effectively removes the development potential as a factor in the property taxes.
Exemptions - Exempting favored classes of real estate (such as farms, ranches, cemeteries or private conservation parks) from the property tax altogether or assesing their value at a very minimal amount (for example, $1 per acre).
Forcing higher density housing - In the Portland, Oregon area (for example), local municipalities are often forced to accept higher density housing with small lot sizes. This is governed by a multi-county development control board, in Portland's case Metro.
Urban growth boundary or Green belt - Government declares some land undevelopable until a date in the future. This forces regional development back into the urban core, increasing density but also land and housing prices. It may also cause development to skip over the restricted-use zone, to occur in more distant areas, or to move to other cities.
Property tax has been thought to be regressive (that is, to fall disproportionately on those of lower income) when not correctly implemented because of its impact on particular low-income/high-asset groups such as pensioners and farmers in drought years. Because these persons have high-assets accumulated over time, they have a high property tax liability, although their realized income is low. Therefore, a larger proportion of their income goes to paying the tax. In areas with speculative land appreciation (such as California in the 1970s and 2000s), there may be little or no relationship between property taxes and a homeowner's ability to pay them short of selling the property. This issue was a common argument used by supporters of such measures as California Proposition 13 or Oregon Ballot Measure 5; some economists have even called for the abolition of property taxes altogether, to be replaced by income taxes, consumption taxes such as Europe's VAT, or a combination of both. Others, however, have argued that property taxes are broadly progressive, since people of higher incomes are disproportionately likely to own property. These two points of view are not incompatible - it is possible for a tax to be progressive in general but to be regressive in relation to minority groups. However, although not direct, and not likely one-to-one, property renters are subject to property taxes as well. The owner's cost of taxation is passed on to the renter (occupant).
As property increases in value the possibility exists that new buyers might pay taxes on outdated values thus placing an unfair burden on the rest of the property owners. To correct this imbalance municipalities periodically revalue property. Revaluation produces an up to date value to be used in determination of the tax rate necessary to produce the required tax levy.
A consequence of this is that existing owners are reassesed as well as new owners and thus are required to pay taxes on property the value of which is determined by market forces. In an effort to relieve the frequently large tax burdens on existing owners communities have introduced exemptions.
In some states, laws provide for exemptions (typically called homestead exemptions) and/or limits on the percentage increase in tax, which limit the yearly increase in property tax so that owner-occupants are not "taxed out of their homes". Generally, these exemptions and ceilings are available only to property owners who use their property as their principal residence. Homestead exemptions generally cannot be claimed on investment properties and second homes. When a homesteaded property changes ownership, the property tax often rises sharply and the property's sale price may become the basis for new exemptions and limits available to the new owner-occupant.
Homestead exemptions increase the complexity of property tax collection and sometimes provide an easy opportunity for people who own several properties to benefit from tax credits to which they are not entitled. Since there is no national database that links home ownership with Social Security numbers, landlords sometimes gain homestead tax credits by claiming multiple properties in different states, and even their own state, as their "principal residence", while only one property is truly their residence. In 2005, several US Senators and Congressmen were found to have erroneously claimed "second homes" in the greater Washington, D.C. area as their "principal residences", giving them property tax credits to which they were not entitled.
Undeserved homestead exemption credits became so ubiquitous in the state of Maryland that a law was passed in the 2007 legislative session to require validation of principal residence status through the use of a social security number matching system. The bill passed unanimously in the Maryland House of Delegates and Senate and was signed into law by the Governor.
The fairness of property tax collection and distribution is a hotly-debated topic. Some people feel school systems would be more uniform if the taxes were collected and distributed at a state level, thereby equalising the funding of school districts. Others are reluctant to have a higher level of government determine the rates and allocations, preferring to leave the decisions to government levels "closer to the people".
In Rhode Island efforts are being made to modify revaluation practices to preserve the major benefit of property taxation, the reliability of tax revenue, while providing for what some view as a correction of the unfair distribution of tax burdens on existing owners of property.
The Supreme Court has held that Congress cannot directly tax land ownership, unless the tax is apportioned among the states based upon representation/population. In an apportioned land tax, each state would have its own rate of taxation sufficient to raise it pro-rata share of the total revenue to be financed by a land tax. Such an apportioned tax on land had been used on many occasions up through the Civil War.
Indirect taxes on the transfer of land are permitted without apportionment: in the past, this has taken the form of requiring revenue stamps to be affixed to deeds and mortgages, but these are no longer required by federal law. Under the Internal Revenue Code, the government realizes a substantial amount of revenue from income taxes on capital gains from the sale of land, and in estate taxes from the passage of property (including land) upon the death of its owner.
The Supreme Court has not directly ruled on the question of whether Congress may impose an unapportioned tax on the "privilege" of owning land with the "measure" of the tax being the value of the land.