Federal Tax Deductions and the Demand for Local Public Goods

Property taxes are the primary funding mechanism by which local governments pay for public goods. In the United States, the federal income tax system provides a subsidy to this cost by allowing taxpayers to deduct property taxes on their federal income tax returns. Using local referendum approval rates, we confirm a positive relation between the demand for public goods and the share of residents deducting property taxes. Based on this evidence, we develop a theoretical model that accounts for the ability of residents to deduct their property taxes to demonstrate the capitalization of public goods into house values. We empirically support the model’s predictions using cross-sectional variation in educational spending. Thus, our results suggest that the 2017 Tax Cut and Jobs Act (TCJA), which increased the standard deduction and reduced the share of taxpayers who deduct property taxes, has the potential to restore equity in the property tax system.