Capitalization is a concept employed in the study of financial markets to describe the economic process by which the future flow of costs and benefits accrued by the owner of an asset are reflected in the market value of that asset. The capitalization concept has been implemented extensively to study variations in urban land values and the location choices of urban land users. For instance, the literature surrounding the estimation of so-called bid-rent models of urban land valuation (see, for instance, Alonso, 1964; Muth, 1969; Henderson, 1985) explored the influence of accessibility to the urban commercial center on land values and, as a result, the location choices of urban land users. Fundamentally, the bid-rent models assert that urban land values, in particular housing values, decline as distance from the urban center increases. Consequently, variation in distance from the urban center or commuting time is capitalized into urban housing values.
In a sense, the property tax and public service capitalization studies initiated by Oates (1969, 1973) extended or expanded upon the bid-rent approach and tested the notion that urban land users select community locations based upon the property tax and public service levels established within each community. The capitalization literature stems directly from the model of local public goods provision and competition among communities presented by Tiebout (1956). Tiebout posits that urban land users migrate to and from different communities based upon the public service packages offered, and tax prices established, within those communities. Oates reasoned that the capitalization effect could be employed to measure the degree to which land users recognize and value the fiscal benefits and costs of a particular community relative to other communities in an urban area. According to Oates, under conditions of property tax and public service competition among urban communities vying to attract land users, capitalization of the tax and service differences will arise due to the varying levels of demand for land within each competing urban community.
Much of the capitalization literature emphasizes the demand-side analysis of urban land markets (see, for instance, Oates 1969, 1973; Brueckner 1979). Oates, Brueckner, and others posit that demand for higher public service levels or lower property tax levels by mobile urban land users serves to bid up land values in communities with preferred service and tax levels. Consequently, this literature predicts that under long run equilibrium conditions, fiscal differences among communities in an urban area will be capitalized into real estate values (4). The empirical research on property tax and public service capitalization in urban housing markets has shown rather consistently that capitalization does occur. However, the capitalization rates estimated in these studies have varied substantially and most have fallen below 100 percent (Bloom, et al., 1983; Yinger, et al., 1988). Bloom et al. (1983) and Yinger, et al. (1988) applied more appropriate discount rates and time horizons to the results of existent empirical capitalization studies. The results of these analyses suggest that interjurisdictional property tax variations are capitalized into house values at rates of anywhere between 30-40 percent and 100 percent.
Several reasons have been posited for empirical estimates suggesting that most often fiscal differentials are undercapitalized into property values (estimated capitalization rates of less than 100 percent). Chief among these reasons is the claim that capitalization is really a short run phenomenon. That is, in the short run, demand for preferred property tax/public service packages will outstrip the supply of communities providing those preferred packages. As a result, the empirical studies have observed transitory increases in real estate prices due to "an imperfect matching of individual preferences and public goods consumption opportunities [that won't hold in the long run] (Pauly, 1976, 239)." As a result, several policy analysts (Edel and Sclar 1974; Hamilton, 1976, Pauly, 1976, Epple, Zelenitz, & Visscher, 1978) have chosen to highlight the supply-side of urban land markets in analyzing capitalization of property tax and public service levels. They have argued specifically that long run equilibrium would not be characterized by capitalization of fiscal differentials. Rather, under a perfectly elastic supply of communities citizen preferences for public services would be exactly matched with public service consumption opportunities. In the long run, landowners and developers will respond to the demands of urban land users by increasing the supply of developed property in communities having the preferred property tax and public service levels. Consequently, capitalization of fiscal differences among communities will disappear.