A look at whether Philadelphia's 10-year tax abatement should continue

The residential tower under construction in November 2017 will be part of the East Market mixed-use development. With a healthy real estate market, the 10-year tax abatement benefit only flows to developers.

The Philadelphia housing market is doing just fine.

Sales are strong, and although prices have softened recently, the increase over the year is still solid. What’s more important is that when you compare the current market to that of 10 or 20  years ago, it looks like a totally different city. And that raises the question: Should the City of Philadelphia continue to subsidize construction by allowing the 10-year tax abatement to continue?

First, what is the 10-year tax abatement and how does it work?

In 2000, Philadelphia enacted a tax-abatement law that provides a tax exemption for all new construction for 10 years. Simply put, if you buy a newly built home or a unit in an improved building, you don’t have to pay real estate taxes for a decade.

The abatement was implemented because the city was hemorrhaging population and, with the cost of construction high, there was little residential or commercial building taking place. To change that, the city created what a recent Philadelphia Controller’s Office report states is “one of the most all-encompassing property-tax incentives in the nation.”

And, indeed, building flourished. Housing starts have boomed over the last decade and prices have appreciated faster than anywhere else in the nation over that period, according to an analysis by Kevin Gillen at the Lindy Institute.

But was the abatement the reason for the booming housing market? That is an issue for debate.

The theory behind the abatement is simple. Given the high cost of construction in the city, developers need elevated prices for their units. What the abatement does is allow the developer to get a higher price than if there were no abatement.

Why is that the case? A person buying a home looks at three major costs: the price, the mortgage rate, and the taxes. Together, they create the monthly payment.

When you abate real estate taxes, that portion of the monthly payment disappears, lowering the total monthly payment. In theory, that allows the buyer to purchase a higher-priced unit than they would be able to afford if they had to pay property taxes. And the higher prices then allow more construction to occur.

In essence, the developers get higher prices and buyers pay less, all paid for by the city receiving less in real estate taxes for a decade.

But it isn’t that simple. The assumption is that both the developer and the buyer get a share of the abatement. It’s how much of the tax break each gets that matters.

Who wins the battle for the abatement depends upon the state of the housing market. If it is weak, the developer will not be able to capture a large part of the abatement. This would limit the ability of the developer to raise prices and therefore build new units.

Conversely, if the market is strong and demand is high, developers might have the ability to capture the entire value of the abatement. That allows them to build higher-cost housing and increase their profits, but the buyer gets little reduction in cost.

It’s the market, not the abatement, that drives most of the construction.

Right now, Philadelphia’s revitalization is being triggered by a change in the fundamentals of the Philadelphia economy.

All the large trends, whether it be millennials wanting to live in high-density, amenity-rich locations, baby boomers looking to escape their McMansions and move into Center City, or businesses following their workers back into the city, show that Philadelphia is on the right side of economic forces driving growth.

And that has translated into a strong housing market and rising prices, making it questionable whether the abatement is needed anymore, especially given the types of units that are being subsidized.

Most of the value of the abatements goes to higher-priced units: 7 percent of the abated properties have value in excess of $700,000 but they receive 51 percent of the tax benefit, according to the controller’s report. And those are concentrated in just a few neighborhoods of the city.

Undoubtedly, when the market was weak, the tax abatement accelerated construction in Philadelphia. But the market is no longer weak.

The abatement should be modified. Set an upper limit on price, limit the length of time of the abatement, and, most important, factor in the condition of the market. When the market is weak, the abatement would expand, but when it is strong, it would wither.

Why Philadelphia is heavily subsidizing builders in this strong market, even given the elevated cost of construction, is beyond me.