Capitalization of Federal Taxes, the Relative Price of Housing, and Urban Form: Density and Sorting Effects

We investigate the impact of the tax treatment of owner-occupied housing on urban form in an economy in which high and low income households choose among city and suburban communities. Because housing tax policies differentially affect the relative, after-tax price of housing for high and low income households, and because the extent of capitalization of housing tax policies can differ across city and suburban communities, our analysis finds that housing tax policies can affect not only the density of the metropolitan area, but also can influence where rich and poor households choose to live. The impact of housing tax policies differs depending upon the extent to which the subsidy is capitalized into city land prices and whether a land use constraint such as suburban large lot zoning exists to make poorer households less mobile. If the rich and poor both are fully mobile, increasing a subsidy to home ownership that is positively correlated with the income of the owner leads to the decentralization of both rich and poor; the greater the extent of capitalization, the larger the decentralization impact. In the presence of binding large lot zoning in the suburbs, the rich have a greater incentive to decentralize while the poor are constrained to the city. Thus, it is only when the mobility of the poor is restricted that housing tax policy of the type we have in the U.S. could have helped exacerbate the intense residential sorting by income that we see in many parts of the country. Finally, it is noteworthy that our analysis of community choice is not driven by different preferences for city or suburb that may be associated with the income elasticity of housing demand. Rather, our conclusions arise from changes in relative after-tax housing prices faced by poor and rich households. Determining the empirical relevance of prices versus preferences in this matter should be an urgent task for future research.