Residential Stability or Rational Bubble: Proposition 13 in Southern California

California’s Proposition 13, which limits the growth of property tax to 2 percent per year, provides homeowners an incentive to remain in their housing units and thus contributes to residential stability. Yet, with fast home price appreciation, new home buyers may purchase a home and then sell it again within a short period of time. Even though they incur transaction costs, they can gain by the appreciation. Under Proposition 13, faced with a disproportionately large property tax relative to those homeowners who purchased their homes a long time ago at a much lower price, the new homebuyers have an additional incentive to trade homes fast in an up market to avoid paying a high property tax. We call this short term residential trading ‘Proposition 13 risk arbitrage’ and predict that Proposition 13 induces additional short-term residential trading, which adds to the underlying residential market speculation. Cross-sectional variations of the residential holding periods over the 1993 to 2001 period in the five counties of Southern California are generally consistent with the predictions based on Proposition 13 induced trading: Households which face a higher property tax per square foot and those that experience larger capital gains show a shorter holding period. We also explain the time variation of the aggregate residential holding period using the Proposition 13 risk arbitrage argument.