(2013) 43, 81–96 The Review of Regional Studies The Official Journal of the Southern Regional Science Association The Responsiveness of Tax Lien Investors in English Auctions to * Matching Rules: Evidence from Illinois Joshua J. Millera and Silda Nikajb aDepartment of Economics, University of Illinois at Chicago, USA bDepartment of Economics, Texas Christian University, USA Abstract: Auctions allowing competitors to match the current high bid are thought to be suboptimal, particularly compared to auctions where new bids must exceed the current high bid (Milgrom, 2004). To date no study has examined, empirically, the effect of allowing matching bids. A recent policy innovation in Illinois provides an opportunity to estimate the effect of matching on winning bids. Using administrative data from five suburban Illinois counties on the auction of 127,073 liens, we find that an English auction design that allows matching is associated with higher winning bids when compared to an English design that does not allow matching. These higher winning bids increase interest fees on tax delinquent property owners by 20 percent. The paper is the first to estimate the cost of matching on auction outcomes. Keywords: auction design, property tax JEL Codes: D44, H71, R12 1. INTRODUCTION The National Tax Lien Association estimates that $21 billion in property taxes become delinquent each year and $6 billion in delinquent tax liability is offered at tax lien sales annually. A tax lien sale is the sale of delinquent property taxes by a local government to investors. In 2011, local governments in 23 states conducted tax lien sales. The primary method of sale is auction. Auction design varies by state and sometimes within states. Although local governments in the United States have used tax lien sales since 1819 (Carlson, 1951; Swierenga, 1974) and there is a literature that suggests that bidders respond to differences in auction designs (Milgrom, 2004), there remains little empirical evidence on the effect of auction design on bidder behaviors. Estimating the responsiveness of bidders to different auction designs has important implications about the cost of tax delinquency for property owners. To the extent that local governments have discretion in choosing auction designs, the costs of delinquency may be reduced. This is especially true given significant increases in tax delinquency in many large cities during the Great Recession.1 * We are grateful to editor Michael L. Lahr and two anonymous referees for their invaluable comments. We also thank Nathan B. Anderson, Rebecca M. Hendrick, Robert Kaestner, David F. Merriman, and Joseph J. Persky for helpful guidance. We thank participants of the Southern Economic Association Annual Meeting for insightful comments and discussion. Miller is a Housing Policy Economist. Nikaj is an Assistant Professor of Economics. Corresponding Author: Silda Nikaj, e-mail: [email protected] 1 See for example, Kerkstra (2013). © Southern Regional Science Association 2013. ISSN 1553-0892, 0048-749X (online) www.srsa.org/rrs 82 The Review of Regional Studies 43(1) In this analysis we are the first to exploit a policy innovation in Illinois. This policy allows county treasurers to choose the tax lien sale auction design. The ability to choose enables measurement of the effect of auction design on bidder behavior. More specifically we compare outcomes between two auction designs, the standard English auction, which forces new bids to exceed the current highest bid (nonmatching), and a modified English auction that allows new bids to match the current highest bid rather than having to exceed it (matching). We use administrative data from the auction of 127,073 liens in five suburban counties bordering the city of Chicago from 2005 to 2011, and find that the English matching design is associated with a 20 percent increase in the cost of tax delinquency for property owners over that they incur via the standard design. The average property owner in the English matching auction with an outstanding tax delinquency of $4,496 paid $117 more in the first year of delinquency when compared to similar liens offered in the English nonmatching design. While the choice of auction design is endogenous, we argue that county treasurers did not choose these auction designs to affect winning bids: Rather they chose them to reduce administrative and financial burdens that sales impose on local governments. The findings show that the association between matching rules and winning bids is robust to different sample restrictions suggesting that the relationship is likely causal. An untested maintained hypothesis of the regression model is that the auction format affects auction outcomes. Furthermore, the findings directly support the observation and untested hypothesis of a previous study by Milgrom (2004). The results are important not only to the design of tax lien auctions but are applicable to the design of other auctions with experienced bidders. 2. TAX LIEN SALE AUCTION DESIGN Although Illinois state law allows counties to determine their own tax lien sale auction design, state law dictates some rules common to all tax lien sale auctions. County governments offer liens in sequential order one parcel at a time by township and property identification number (PIN). In all counties, investors bid on individual liens by declaring an interest rate between 18 and 0 percent. Bids are entered in whole percentage point increments (i.e. 0,1,2,…,18). The bidder with the lowest interest rate wins the right to pay the delinquent property taxes in exchange for repayment plus interest. The property lien is transferred from the county to the winning bidder as collateral. Interest rates of 18 percent represent a low price for investors, in which case the investor earns the highest possible interest permitted by state law. Interest rates of zero represent a high price as winning bidders earn no interest during the first year of delinquency. Zero interest-rate bids are common in the observed sample. Winning bidders who purchase liens at any interest rate gain first rights to purchase all subsequent delinquency on the same property at a fixed rate of 18 percent, according to Illinois law. Liens not sold at auction are returned to the county at an interest rate of 18 percent. The two auction designs compared in our analysis are English matching and English nonmatching (the standard English auction). In the English matching auction, investors submit a bid by raising a paddle. The auction concludes when only one bidder remains at the lowest interest rate charged or multiple bidders with matching bids are unwilling to bid at a lower interest rate. In cases where more than one investor offers the same low bid, the county treasurer chooses a winner at random. It is rare for liens sold to investors not to receive more than one bid at the same low rate; often, ten or more investors bid the same interest rate. © Southern Regional Science Association 2013. MILLER & NIKAJ: THE RESPONSIVENESS OF INVESTORS TO MATCHING RULES 83 In a standard English auction, investors submit a bid by selecting the desired interest rate on a computer screen. All bidders and computers are located in the same room. The first bidder to select the lowest interest rate wins the right to purchase the lien. It is not possible in the English nonmatching auction design for more than one bidder to register the same interest rate. 3. THEORETICAL MODEL In this section, we argue that tax lien sales are common value auctions and show that matching rules affect winning bids. We describe the bidding strategy under each design and discuss the implications of matching rules on winning bids. Tax lien sales are common value auctions because the monetary benefit of lien ownership, which is unknown at the time of bidding, does not vary across investors (Menezes and Monteiro, 2005). Our description of the monetary payoff from lien ownership and the optimal bidding strategy assumes that there are no nonpecuniary benefits to lien ownership. An example of a nonpecuniary benefit would be the additional benefit derived from purchasing the lien on a property close to a family relative. Liens are purchased by investors for the interest earned when property owners pay the delinquent tax bill. Liens are rarely purchased by individuals with the long-term goal of personally occupying the property. For example, from 2005 to 2011, our sample includes only 98 liens that were sold to investors participating in one auction and purchasing one lien. This represents less than 0.1 percent of all liens sold to private investors. In order to derive the optimal bidding strategy for a sequential common value auction, we first model the bidder’s expected payoff. When purchasing a lien, the bidder faces two possible outcomes: redemption or tax foreclosure. In redemption, the property owner pays the delinquent tax bill plus interest. In tax foreclosure, the tax delinquent property owner is forced to relinquish property rights. Winning bidders purchase liens by paying the delinquent tax bill at time t. The payoff from redemption occurs at a time period prior to tax foreclosure, t+1, whereby the winning bidder receives the delinquent tax bill at t plus any interest that accrued since. More formally, let D denote the delinquent tax bill and li the interest-rate bid submitted. Equation (1) provides the present value payoff with redemption. D(1 l ) (1) Payoff with tax redemption = i D (1 ri ) In tax foreclosure, the winning bidder obtains ownership of the property in t+2. The payoff in tax foreclosure is the property market value at tax foreclosure minus the delinquent tax bill and interest. More specifically, let D represent the delinquent tax bill and V the market value of the property at tax foreclosure. Then the payoff with tax foreclosure is provided by Equation (2).