So far, I have been describing the asset that conveys the fiscal externality as tangible property, but the asset could equally be something intangible but persistent, like a reputation for spending each tax dollar more productively. That is, school productivity is not only capitalized, but school districts with high productivity attract households whose taste for education is high.
It is worth noting that empirical evidence suggests that households with an unusually high demand for school spending relative to their incomes live in districts that have property prices that are unusually high given the properties’ characteristics and tax rates that are above-average, but not dramatically so.
In short, property values in a district reflect not just housing services, but (1) the productivity of schools, (2) households’ taste for education, and (3) the degree to which state law constrains households from exercising their most preferred level of school spending and taxes. (State law can also make households less constrained, as I emphasize below.) Of course, we do not observe the division of each property price into the part that is payment for housing and land services and the part that reflects the local public goods equilibrium.
Thus, the variable v, in school finance formulae is impure—it means different things in different districts. It is convenient to write v-t as the sum v^vZ+v/Y^,/?,, vife J, where v* is the asset price of housing and land services and v** is the part of the price that depends on the association of the land with the particular school district /. v** depends on tastes (#,) and productivity (Д). v depends on the tax rate г; under conventional Tiebout equilibrium, but I enter spending (e,) separately in the v** function since state laws can break the equality between r/v* and er
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How School Finance Equalization Schemes Affect School Spending
The results just described are for Tiebout equilibria in which district budget constraints are given by local property tax finance: e,-Z’v,. SFE schemes change the equilibria by changing the budget constraints -for instance, to the foundation aid budget constraint given by equations (4) and (5) or to the guaranteed tax revenue budget constraint given by equations (6) and (7).
Of course, categorical aid schemes also change district budget constraints. What makes categorical aid and SFE schemes similar is that they tax districts on some measure of ability-to-pay (usually income in the case of categorical aid, v* in the case of SFE). These taxes cause the usual distortions: income taxes distort income-related decisions like labor supply; property taxes distort decisions about purchases of housing and land services. What makes SFE schemes peculiar is they do not just tax a measure of ability-to-pay. They also tax v*\ which is a function of taste for education, school productivity, and actual levels of school spending. We will see that this feature of SFE schemes has peculiar effects.