In order to understand school finance equalization, we need a few results from the Tiebout literature. First, in Tiebout equilibrium with local property tax finance, productivity differences between school districts are capitalized in house prices. If a district has a reputation for consistently being better run and using its money more efficiently than neighboring districts, households will be willing to pay more for houses in the district because the tax burden on homeowners will be small for any given level of school quality.
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Second, in Tiebout equilibrium with local property tax finance, households’ maximizing their utility is equivalent to households maximizing their property values. That is, households actually maximize their utility, but their actions are identical to those they would pursue if they were attempting to maximize their property values. If binding constraints are put on the property tax rates they can set or on the property values they can tax, their property values will end up being lower.
This is simply a matter of comparing a constrained with an unconstrained maximum. Another way to think of this result is based on recognizing that property plays two roles in a Tiebout market. Property provides people with housing and land services, but is it also the “ticket” whereby they can attach themselves to a specific school district and enjoy a specific local goods equilibrium. If we eliminate all or part of the specificity of the “ticket,” we eliminate some of the usefulness, and thus, value of property. In short, property values are partly a function of the freedom a households have to set spending and property taxes as they prefer.
Third, districts that contain assets that convey fiscal externalities on residents tend to attract households with high taste for education (that is, households that want to spend above-average shares of their incomes on schooling). To see this result, consider a district that contains business or other property that forms a share of the property tax base far out of proportion to the local services it consumes (ski resorts are an extreme example). Households are willing to more for a house in the district because the tax burden on homeowners is small for any given level of local spending.
This is the capitalization response. But, more importantly, the district attracts households whose taste for education is high because the absolute size of the fiscal externality is increasing in the tax rate. As a result, districts that contain households whose taste for education is high systemically have capitalization forming a large share of house prices, so that entire districts can be filled with residents all whom have a high taste for education and all of whose house prices contain a relatively large amount of capitalization.