Imagine, if you will, Tinyville, a community of only ten houses. All ten houses were the same size and style, built at the same time on similarly-sized lots, using similar architectural drawings and building materials, each with comparable views and amenities, and each sold to its initial owner for the same price, $ 250,000. Assuming the fair market value of each of these houses was $ 250,000, (because after a reasonable amount of time that's the price at which the sellers and buyers had meetings of the minds, neither being under duress,) Tinyville's tax assessor valued each property at $ 250,000 , resulting in an underlying total property value of $ 2.5M for all of Tinyville.
Like any municipality, Tinyville has expenses: police & fire departments, schools & libraries, water & sewer, sanitation workers, judges & clerks, engineers & inspectors, tax assessors & collectors, officials, and secretaries. To keep the math simple, let's imagine that Tinyville's annual budget is a mere $ 100,000, and that it has no other sources of revenue (such as parking meters, local sales or income taxes, or hunting / fishing permits). In order to meet its annual expenses, Tinyville's tax assessor divides its $ 100,000 of budgeted expenses (known as a total tax levy) by each property's proportionate share of the $ 2.5M total assessed value of the community. Dividing $ 250,000 by $ 2.5M means that each house is responsible for 10% of Tinyville's property tax levy. Each homeowner (or their mortgage bank) gets a tax bill for $ 10,000.
For years, everyone is happy in Tinyville. The families each have kids in Tinyville's schools, they march in Tinyville's parades, and compete in Tinyville's pie-eating contests. In the natural course of events, two of the original families were more prosperous than others and moved into better digs in Mediumville, one retired to Southville, one got transferred to his company office in Westville, and one died in a tragic car accident, but their heirs in Bigville did not want to move back to their family homestead. Anyway, five of the homes went on the market and because the market had been doing well for the past several years, four were sold for $ 300,000 … except the one belonging to the heirs of the deceased couple – they let the house fall into disrepair, stopped mowing the lawn, and eventually squatters moved in and started trashing the place. When they finally sold it as a "handyman special," they got $ 150,000 for it.
Before any year tax assessment becomes "final," it is sent to each homeowner to review. Each homeowner has an opportunity to dispute the assessment. The five original homeowners continued to be assessed at a rate commensurate with their $ 250,000 property value, and knowing that many of their neighbors sold their comparable homes for $ 300,000, they silently accepted this assessment. The four new owners who paid $ 300,000 each are also assessed at $ 250,000. Strangely, it is illegal for a municipality to perform a "spot assessment" of individual properties so despite the "fair market value" of those four homes has increased by 20% since last appraised, they continue to be assessed at $ 250,000 each. The tenth home, purchased by the handyman for $ 150,000, is also assessed at $ 250,000, but he disputes his assessment. He argues that the fair market value of his home should be based on his recent purchase price, and through the various legal methods at his disposal, he has the house reassessed at $ 150,000.
Assuming the total tax levy is unchanged at $ 100,000, what happens to each homeowner's property taxes? Nine of the ten houses are still assessed at $ 250,000 each, but the last is now assessed at only $ 150,000. One might quickly (and incorrectly) guess that the houses with unchanged assessed values would have no change in their $ 10,000 property tax bill, and that the tenth house would pay just $ 6,000, but that doesn't add up correctly; Tinyville needs to collect $ 100,000 in taxes to balance its budget, and this formula only adds up to $ 96,000. What actually happens is that the denominator changes, too. Tinyville's total assessed property value is recalculated based on each property's assessed value, and now adds up to just $ 2.4M. That means that each of the $ 250,000 houses now accounts for just over 10.4% of the total, and is now responsible for that percentage of the $ 100,000 levy, increasing each of their assessments to $ 10,417. The handyman's $ 150,000 assessed value accounts for 6.25% of the total, so he's now responsible for just $ 6,250 of Tinyville's tax levy.
Some (including the handyman) would argue that the handyman's house is worth less, and consequently, he should pay less tax than his neighbors. Others (including his neighbors) would argue that his house is the same size and shape, takes up as much land, and places the same demand on Tinyville's police, fire, schools, libraries, sewers, and other services, and that he should pay the same amount as the other houses. Some (including the original five families) would argue that the resold houses should be assessed at their new, higher market values, and that the new owners should pay proportionally more taxes. Others (including the four new owners) would argue that the fair market values of their homes (as evidenced by their sale prices) are indicative of the actual fair market value of the five unsold homes, despite the fact that those homes haven't recently changed hands. These are the sort of issues that confound homeowners and plague tax assessors, assessment review boards, and courts in every municipality, every year.
In a perfect world, when the handyman files for building permits to repair and restore his home's value, the new value he creates by the work he does should bring his tax assessment back in line with the other comparable houses, thus reducing his neighbors' percentage of the total tax, accordingly. Unfortunately, not everyone applies for building permits, and not every project even requires building permits. Upgrading your kitchen appliances improves the value of your home without requiring building permits. Many municipalities don't require a building permit to add a new layer to your roof or to retile your bathrooms. Of course, there are also homeowners who build bedrooms in attics or lofts over their garages without permits, and not every new home buyer is savvy enough to realize that they are paying for such unpermitted improvements. If you complain to the tax assessor that your neighbor has an unpermitted finished basement, the tax assessor does not have the same authority as a building inspector to knock and demand to see that basement so as to tax them appropriately … and not every building department inspector is willing to perform inspections on an anonymous tip, so you may have to go on record as the guy who ratted out his neighbor. Consequently, a lot of home improvements are not reflected on the tax assessment rolls.
Since buying a home in a market downturn gives you the ability to grieve your tax assessment based on its new apparent fair market value, other home owners can actually use your new "fair market value" to argue that their house is comparable to yours, and that their assessment should be lowered, too. This creates added burden on the assessors as they try to determine new values of homes that haven't recently sold based on evidence created by comparable homes that did. As more and more homeowners grieve their assessments, it reduces the denominator in the municipality's total assessed value, increasing the actual tax bills for houses for which assessments haven't been grieved. Naturally, that reinforces the process, inciting more and more homeowners to grieve their taxes, creating more and more work for assessors. However, taken to the unimaginable extreme, in a community where home values have fallen, it may take a few years for all of the homeowners to realize that they are being unfairly assessed (as compared to their neighbors), but ultimately, when the last of them finally grieves his taxes, everyone's proportion to the new denominator should be comparable to their proportion to the original denominator, meaning that they'll all on average, eventually pay just about as much tax as they did before. In the intervening years, the ones who got onboard first and had the largest and earliest reductions in their assessed home values will reap the greatest short-term benefits. Some would go so far as to argue that this is fair, like so many other instances in life when the early bird gets the proverbial worm.
The intervening chaos and disparity, however, causes more work, thus costing municipalities more in assessments, review boards, and grievance hearings. In the worst cases, when grievance processes fail and are left for courts to decide, municipalities have to pay unanticipated refunds to vindicated homeowners, which reduces their immediate coffers and further increases tax levies in subsequent years to make up for those losses. For scholars of economic theory, Keynes would argue that these machinations are a necessary and productive part of the system, and that they employers who otherwise would earn less; these lawyers rent offices, hire staff, and buy office supplies, and in effect, keep the economy's wheel turning. Hayek would retort that these legal costs do not so much enrich the system, as they do redirect capital that would have been been employed elsewhere, such as the tax savings permitting the homeowners to buy new furniture, hire a gardener, or take a vacation. He would consider these inefficiencies in the tax assessment process an unnecessary cost that allocated resources in a less-than-optimal manner … and I'd tend to agree with him. I don't know what the solution is, but I know that we should try to come up with a better one.