Property tax limits and local fiscal behavior: did Massachusetts cities and towns spend too little on town services under proposition 2 1/2?

This paper examines the impact of a specific local tax limit, Proposition 2 in Massachusetts, on the fiscal behavior of cities and towns in Massachusetts and the capitalization of that behavior into property values. Proposition 2 places a cap on the effective property tax rate at 2.5 percent and limits nominal annual growth in property tax revenues to 2.5 percent, unless residents pass a referendum (an override) allowing a greater increase. The study analyzes the 1990-94 period, a time when Massachusetts municipalities faced significant fiscal stress because of a 30 percent cut in real estate aid and a demographically driven increase in school enrollments. The findings include the following: (1) Proposition 2 significantly constrained local spending in some communities; (2) constrained communities realized gains in property values to the degree that they were able to increase school spending despite the limitation; and (3) changes in school spending were a much stronger influence on house price changes than were changes in nonschool spending. These findings are confirmed using several different econometric approaches, including a two-stage technique that directly estimates how close each community's spending was to what it would have been in the absence of Proposition 2.