Land Tax: Making an Efficient Tax More Equitable

Economists almost universally recognise that a land tax – an annual tax on the unimproved value of land – is amongst the most efficient taxes available to central and local government. I recently discussed efficiency advantages of a land tax in Macquarie University’s annual Public Lecture in Honour of Henry George. In another recent paper, I analysed equity issues associated with a land tax.

Efficiency

A key reason for the tax’s efficiency – identified by classical economists such as François Quesnay, Adam Smith, John Stuart Mill and Henry George – is that production and labour supply remain unaffected by the imposition of a land tax. Instead, the price of land – which is in fixed supply – adjusts to the imposition of a tax.

If central government were to impose a tax on unimproved land value it could reduce other forms of taxes, almost all of which distort economic decisions. Thus, revenues gained through a non-distortionary land tax can be used to reduce marginal rates of income tax and of other distortionary taxes.

A particular form of land tax, originally advocated by John Stuart Mill, offers an effective alternative to taxing capital gains at the point of sale. Mill proposed a small annual tax that applies to the current value of land less the value of the land at the date of the introduction of the tax. These increases in land value, which represent capital gains, should ideally be taxed in a way that is commensurate with taxes on other forms of income.

However, capital gains taxes are not generally structured to tax these increases in land value in a manner consistent with tax on other income. A tax on unrealised capital gains can result in severe cashflow difficulties which makes it impractical. A tax on realised capital gains has the effect of locking in ownership, so reducing the flow of properties for sale on the market. This reduced flow of properties reduces the liquidity and efficiency of the property market.

In earlier work, Andrew Coleman and I showed that a land tax imposed on the increment in land value following a certain date serves as an amortised capital gains tax. If the land tax rate is set equal to the real interest rate times the desired capital gains tax rate, the present discounted value of the land tax revenue equals the desired revenue from a capital gains tax. The annual (and permanent) nature of the tax means there is no incentive to delay sale of a property. The small annual payments (as in Mill’s proposed tax) reduce the cashflow difficulties of an unrealised capital gains tax; in cases of severe hardship for land-rich but income-poor households, the tax could be accrued until sale.

A land tax is also an efficient option at the local government level. Consider the decision of a property owner to add an extra dwelling to their existing property under two different forms of local council rates. One form bases its rates on the land value of the property. The other bases its rates on the capital (or rateable) value of the property, comprising the land value plus the value of ‘improvements’.

Under land value rates, the owner must find someone willing to pay at least the construction cost of the unit for the development to be profitable. Under capital value rates, only a prospective purchaser who is willing to pay at least the construction cost plus the present discounted value of rates on the unit will wish to purchase it. Hence, a capital value base for rates creates an inefficiency that distorts development decisions relative to a land value base.

Equity

The price adjustment following imposition of a land tax raises equity issues since only landowners are affected by the tax change. In my recent paper, I analysed these equity issues and suggested some modifications of a land tax that mitigate concerns about its imposition.

Equity issues can be considered in relation to ‘vertical equity’ and ‘horizontal equity’. Vertical equity aims to have taxes fall more heavily on higher income or higher wealth people. Horizontal equity is concerned with having the tax system treat similar people (for example, people on similar income) in similar ways.

A land tax is vertically equitable. Evidence shows that higher income and/or higher wealth people tend to own more land (and more valuable land ) than do poorer people. Thus, on balance, a land tax will tax richer people at a higher rate than poorer people.

However, the ‘on balance’ caveat above points to a weakness of a land tax in terms of horizontal equity. A wealthy person who holds all their wealth in shares or bonds (or in overseas property) is exempt from the tax while a person who holds some or all of their wealth in (domestic) land, pays the tax.

One way around this issue is to tax only the increment to land value as per JS Mill’s formulation. If accompanied by a comprehensive tax on other forms of income from wealth, the horizontal equity issue disappears.

Another way of mitigating the horizontal equity concern is to include a threshold below which no land tax is paid. To avoid efficiency costs, the threshold should be structured as the first $X dollars per hectare of land value being exempt from the tax: the higher is X the smaller is the proportion of land value that is taxed.

This threshold approach also has other advantages. First, it makes a land tax more progressive since people on lower valued urban land will pay little or no tax. Second, those on rural land – especially farmers and foresters – can be effectively exempted from the tax since rural land is worth little compared with urban land. This exemption removes a major political economy roadblock to a land tax.

Recommended approach

The introduction of a land tax, with an exempt value per hectare, meets both vertical equity and efficiency tests. The threshold also helps in reducing horizontal equity concerns. If introduced at the central government level, the resulting tax revenues can be used to reduce rates of distortionary tax so contributing to improved economic performance. If introduced at the local government level, the tax assists in promoting more efficient urban development (relative to a capital value tax).

Why then, is the tax not more commonly used in practice? In 1890, Henry George – perhaps the most prominent of all land tax advocates – described these reasons concisely:

If the tax on land values is so advantageous a mode of raising revenue, how is it that so many other taxes are resorted to in preference by all governments? The answer is obvious: The tax on land values … falls upon the owners of land, and there is no way in which they can shift the burden upon anyone else. Hence, a large and powerful class are directly interested in keeping down the tax on land values and substituting, as a means for raising the required revenue, taxes on other things … Nearly all of these taxes are ultimately paid by that indefinable being, the consumer.