Local property tax reform and municipality spending efficiency

Local governments provide a plethora of public services. To finance themselves, local municipalities rely on self-generated revenues, mostly on taxation. At the same time voters usually advocate for tax and expenditure limitations. Voters’ desire to lower the price while wishing to maintain the existing level of public services, can be interpreted as pressure on local governments for increased efficiency.

This study assesses the short-term impact on municipal efficiency that stems from the 2008 property tax reform. The property tax revenues accrue to the municipality and as the reform reduced the maximum threshold for the property tax rate, it potentially limited the amount of tax revenues generated locally. Several municipalities around the metropolitan areas of Lisbon and Porto, and in the coastline and in the south, whose pre-reform property tax rate was set at the maximum allowed, were forced to decrease their property tax rates. In fact, before 2008, a municipality charged on average 0.4% of Imposto Municipal sobre Imóveis (IMI) and 0.71% of Contribuicão Autárquica (CA). After 2008, the average of these property tax rates decreased to 0.35% and 0.65%, respectively for IMI and CA. This paper estimates the local government efficiency changes by comparing the post-reform efficiency of municipalities that were forced to reduce their property tax revenues with those that did not have to change their property tax rate.

The results show that the average input efficiency scores declined from 0.575 before the tax reform to 0.488 after the tax reform. This change was transversal to municipalities that were obliged to reduce the property tax rate and to the ones that maintained the tax rate. The effect of the property tax reform however is that for the municipalities that were forced to reduce the tax rate their efficiency score decreased by less.

The results suggest that the lowering of property tax rate promoted spending efficiency. Over time, of course, the improvements on spending efficiency that come from tax reforms might disappear as local governments find other ways to finance themselves, which complicates the policy evaluation. Local governments might shift their reliance towards non-tax revenues (fees and charges, state transfers and debt) for financing local public services and might create a vertical shift of power and responsibility to the state.

Click here to go to the paper by António Afonso and Ana Venâncio.