Why Site-Value rating is better, and how to implement it with no losers

A guide for local Councillors in Victoria, by Gavin R. Putland* (ver. 2009.10.13).

No reform of local government rates, whatever its economic and moral merits, can be successfully implemented if it would create a class of losers with resources out of proportion to their numbers. The losers would inevitably use those resources to campaign against legislators who supported the reform, and in favour of alternative candidates who opposed it; and the true motives behind the redirection of support would not be stated.

Accordingly we have devised a reform with no losers. Its aim is to stop penalizing ratepayers who add value to their properties by building, rebuilding, extending, and renovating. Under our proposal, for each rateable property, the total Rates bill for the first year of the new system would be the same as in the last year of the old system, and subsequent changes in the Rates bill would depend on changes in the site value (SV), but not the values of any buildings.

To obtain this outcome within the framework of the existing Victorian Local Government Act, all existing local property taxes, including General Rates, Special Rates, garbage and recycling charges, water access charges (but not consumption tariffs), and sewer access charges (but not discharge tariffs), would be replaced by a new General Rate on the site value, while the Municipal Charge would be calculated for each property so that the total tax payable in respect of that property is the same in the first year of the new system as in the last year of the old system.

The "economic and moral merits" of this proposal include the following:

• Property owners who add to the quantity or quality of available accommodation will no longer be penalized by higher Rates bills. There will be more jobs in construction. The shortage of rental accommodation will be alleviated. Housing affordability will improve and in turn will assist job creation in other industries.

• Property owners who allow their buildings to deteriorate will no longer be rewarded with lower Rates bills. Better-maintained buildings will add value to surrounding locations.

• As redevelopment of inner-city sites will no longer incur a Rates penalty, there will be more infill developments and less pressure for greenfield developments on the urban fringe. That means less sprawl, hence shorter commuting distances, hence less pollution and more family time.

• Families that renovate homes at great expense for the benefit of disabled members will no longer be hit with higher Rates bills.

• Except where a site value is computed by subtracting a building value, valuations of buildings will not be needed for rating purposes. This would allow the valuation process to be made less intrusive, involving fewer inspections.

• When given the chance to vote in local plebiscites, the ratepayers of Victoria have usually preferred site-value rating to other rating systems.

Empirical studies overwhelmingly confirm that site-value rating is more conducive to economic activity than rating systems that include buildings in the tax base. We cite a sample of those studies, including some conducted in Melbourne.

Contents

1.  The rational arguments for SV rating

1.1  No equity without affordable housing
1.2  No production without accommodation
1.3  No accommodation without construction
1.4  Consequences of taxing construction
1.5  Corresponding (non-)consequences of taxing site values
1.6  Spurious counter-arguments
  1.6.1  The strange case of net annual value (NAV) 
1.7  De facto building taxes

2.  Implementation with no losers

2.1  How to set the Municipal Charge
  2.1.1  Example
  2.1.2  Note on net annual value (NAV) 
2.2  Advantages of a fixed marginal rate
2.3  Asset-rich, income-poor ratepayers
2.4  Infrastructure and housing affordability

3.  Empirical evidence of the superiority of SV rating

3.1  Terminology of rating systems
3.2  Camberwell, 1920s
3.3  Hutchinson's zonal studies
3.4  Other studies on Melbourne
3.5  Comparisons between Australian States
3.6  South African experience
3.7  North American experience
3.8  The people have spoken (and been Jeffed)

4.  Conclusion

Notes

1.  The rational arguments for SV rating

If we tax buildings, there will be fewer buildings. But if we tax land, there will not be less land. If we tax values of buildings, we will get not only fewer buildings, but also inferior buildings. But if we tax the value of land (exclusive of buildings and other artificial "improvements"), we will get neither less land nor less valuable land, because land is not the product of private effort or enterprise, while its value is conferred by the surrounding community, not by the owner who pays the tax.

The argument for imposing municipal rates on land values alone consists in the elaboration of these simple facts. The argument for any other rating system consists in the concealment or obfuscation of them.

1.1  No equity without affordable housing

From the viewpoint of private entities, the overall supply of residential land is fixed, as is the supply within acceptable distance of any particular services, infrastructure, or job opportunities. Yet access to suitably located residential land is essential. Therefore the land component of the cost of housing is competed upward until it absorbs the people's capacity to pay. If wages and salaries rise due to a "strong economy", so does the cost of housing. If childcare or petrol or food gets cheaper, the cost of housing eats up the savings. What the rest of the economy giveth, the housing market taketh away.

For households, the only gains that are not competed away in the housing market are those that are delivered through the housing market — by policies that reduce the intensity of competition among renters and buyers.

1.2  No production without accommodation

At the risk of stating the obvious, we note that there can be no job creation and no associated wealth creation unless:

• the employer can pay the rent or mortgage on the business premises out of the proceeds of the business; and

• the workers can pay the rents or mortgages on housing within commuting distance of the premises, out of wages that the employer can pay out of the proceeds of the business.

The first condition implies that if commercial accommodation is unaffordable, employment and economic growth will be directly frustrated. The second implies that if residential accommodation is unaffordable, employment and economic growth will be indirectly frustrated because

(a) workers, on the wages offered, cannot afford housing where the jobs are available, or

(b) employers, in view of the wages needed to pay for housing, cannot afford to offer jobs [1].

The implication is that a lack of affordable accommodation not only represents inequity in the distribution of wealth, but also impedes the creation of wealth.

1.3  No accommodation without construction

Again at the risk of stating the obvious, we note that affordability of accommodation requires an adequate supply, hence an adequate rate of construction. Slower construction means tightening supply, causing rents and prices to rise faster than capacity to pay, so that a rising fraction of potential renters and buyers are forced out of the market. Again this offends not only against equity but also against efficiency, because it impedes the economic activities that the excluded renters and buyers were planning to engage in — to say nothing of the fact that construction itself is an economic activity, or that it stimulates further activity both upstream (e.g. in production of building materials) and downstream (e.g. in production and retailing of furniture and appliances).

The necessity of construction does not diminish the significance of the limited supply of land, but makes the effective supply of residential land more limited for some than for others. For those who have the means to develop new estates, the supply of residential land is limited by the willingness of governments to rezone land. For those who have the means to build dwellings (or to have them built), but not to develop new estates, the effective supply is further limited by the willingness of big developers to develop and re-sell their "land banks". For those who lack even the means to build dwellings, the supply of residential land is effectively limited by the supply of dwellings. Those in the last category suffer most from any shortfall in construction.

1.4  Consequences of taxing construction

In view of the above, if values of buildings are included in the base of municipal rates — as they are in almost all Victorian municipalities — the following consequences are to be expected:

1. Property owners who build accommodation or extend or renovate existing accommodation are penalized by higher Rates bills. This deters, or at least reduces the incentive for, construction (including extension) and renovation. Jobs are lost in the construction industry and in upstream and downstream industries. The supply of accommodation is lower, and accommodation is consequently less affordable, than would otherwise be the case. A wide variety of economic activities that would otherwise be viable are rendered unviable by the lack of affordable accommodation.
2. Property owners who allow their buildings to deteriorate are rewarded with lower Rates bills. So buildings indeed deteriorate and become "eyesores" that reduce the values of surrounding locations. Buildings that might have been kept in repair and let to tenants are instead demolished, or boarded up to keep out squatters, further reducing the supply of rental housing.
3. As redevelopment of inner-city sites incurs a Rates penalty, there is less infill development and consequently more pressure for greenfield developments on the urban fringe, hence more urban sprawl, hence longer commuting distances, more pollution and less family time, than would otherwise be the case.
4. Families that renovate homes at great expense for the benefit of disabled members are hit with higher Rates bills.
5. Valuations of buildings are critical in assessing Rates bills. Accurate assessments require accurate building valuations, which in turn require intrusive inspections. Alternatively, lack of intrusion means inaccurate assessments.

1.5  Corresponding (non-)consequences of taxing site values

A site is a piece of ground or airspace, whose value includes the value of any attached rights to construct buildings on that ground or into that airspace or to use the ground or airspace for particular purposes, but excludes the value of any actual buildings or other works. Taxpayers cannot create or eliminate sites. By increasing permitted building heights or rezoning land for more intensive uses, governments can effectively create sites or add value to sites; but these actions are not within the power of taxpayers.

From the viewpoint of taxpayers, then, the supply of sites is fixed. Therefore a recurrent tax on the value of a site, payable by the owner, cannot reduce the supply of sites, but can only induce the owner to use the site more productively in order to generate income to cover the tax — or sell the site to someone who will. Selling the site does not eliminate the site or the need to use it productively, but merely transfers both to the buyer.

So, compared with the above consequences of including building values in the rating base, the effects of rating site values alone are, respectively, as follows:

1. There is no reduction in the supply of sites. But there is an increase in the supply of buildings as site owners attempt to derive income from their sites, for which purpose they usually need buildings (for their own use or for letting to tenants). So accommodation becomes more abundant and therefore more affordable. In the process, jobs are created.
2. Property owners who allow their buildings to deteriorate get no rate reductions to offset the reductions in rents and capital gains. So buildings are better maintained.
3. Infill development is not penalized by higher rates, but is encouraged by the need to derive income from high-value sites in order to cover the rates thereon.
4. Owners who renovate homes for the benefit of disabled persons — or for any other reason — do not suffer any consequent increases in Rates bills.
5. Valuations of buildings are usually not needed, as most site values are calculated by spatial interpolation between other site values that are known from market transactions.

On the last point, note that if a site is sold with a building that is promptly demolished by the buyer, the effective price paid for the bare site is the sale price plus the demolition cost; no valuation of the building is needed in this case. If a site is sold with a building that is not immediately demolished by the buyer, a valuer may need to subtract the building value in order to establish how much of the sale price was site value, but only if there are not enough known nearby site values to permit interpolation.

1.6  Spurious counter-arguments

It might be said that to exclude values of buildings from the rating base is to "narrow" the tax base. But in what sense is the tax base "narrowed"? Rates, by definition, are imposed on property, and every rateable property includes a site. Even the value of a unit in a strata-titled complex includes a site value, as is clearly shown by the fact that units of similar size and quality have different values in different suburbs; the locational component of a property value is attached to the site, not the building(s), because the value of a building is limited by the depreciated replacement cost, whereas a site has a location, and hence a locational value, even if it is not yet occupied by a building. So if only the sites are rated, there is no reduction in the number of taxable properties or property owners, but only a reduction in perverse incentives. Besides, if some things are more fit for taxation than others, it follows that narrowing the tax base is not always a bad idea.

It might be said that if building values are included in the rating base, the incentive to build can be restored by differential rating, with a higher tax rate on vacant lots. But if it is admitted that building should not be discouraged, why not eliminate the problem at the source by rating the site alone? A higher rate for vacant lots raises a new question: exactly how much does one need to build before the lot ceases to be vacant? If that is satisfactorily answered, the owner who builds or preserves more accommodation still pays more tax than the owner who builds or preserves less, as long as the latter builds or preserves something. The "advantage" of such differential rating is that land owners, instead of having an incentive to build nothing and demolish everything, have an incentive to build or preserve as little as possible!

It might be said that if building values are included in the rating base, exemptions can be given for renovations carried out for the benefit of disabled persons. But then what qualifies as a disability? And what building modifications are to be recognized as responses to that disability? What loopholes will be opened up, and what collateral damage will be done while trying to close them? If buildings are excluded from the rating base, these problems are completely and automatically avoided.

Because opulent buildings seem to indicate capacity to pay, it is often said that inclusion of building values in the rating base is "progressive". In fact the reverse is the case, because:

• as explained above, site-value rating enhances housing affordability, which is an indispensable component of economic equity;

• more valuable buildings tend to be newer, and newer buildings tend to be more heavily encumbered with mortgages that offset the owners' "capacity to pay"; and

• the fractions of total property values attributable to buildings (as opposed to sites) tend to be higher in suburbs where the property owners are less wealthy [2] — "McMansions" on small lots in outer suburbs being a familiar illustration.

The last point is moot in that our proposed implementation of site-value rating avoids any redistribution of the rate burden in the transition from the old system to the new. But in that context, any positive correlation between building values and "capacity to pay" is similarly moot.

Also moot, in the same context and for the same reason, is the claim that the combined value of the house and site is better correlated with household income than the value of the site alone. And whenever this argument is not moot, its validity depends on the unstated premise that household income is the ideal tax base, in which case those who offer this argument should be campaigning for a local household income tax rather than any form of property rating!

Continuing the "capacity to pay" argument, it is often said that buildings should be included in the rating base so that owners of multi-unit complexes pay their "fair share". But the mere permission to build a multi-unit complex on a site increases its value and is therefore captured by site-value rating. In answer to this, the building-taxers might further argue that it is unfair to charge a property owner for building rights that are not used. But it is fair in the sense that a site owner who fails to build the maximum permitted number of dwellings is needlessly restricting the supply of accommodation, and thereby needlessly causing serious economic damage [recall subsections 1.1 to 1.3]. If owners are charged for the right to build more dwellings whether they use it or not, they have some encouragement to use it — and that's healthy.

In an attempt to impugn the "green" credentials of site-value rating (less sprawl, shorter commuting distances, less pollution), it is often alleged that site-value taxation causes "overdevelopment", including ecological destruction and demolitions of historic buildings. This argument conveniently forgets that the preservation of natural and man-made heritage can be mandated by zoning restrictions or other laws, and that because such restrictions reduce the market values of the affected sites, they also reduce the taxes payable thereon. It also forgets that some (not all) of the development encouraged by site-value taxation is not additional development, but rather development that has been moved from low-value sites (e.g. on the urban fringe) to high-value sites (e.g. underutilized inner urban sites).

In a further attempt to portray encouragement of development as a disadvantage, it is alleged that site-value rating causes infill development of parks and gardens. This argument forgets that parks and gardens tend to be publicly owned but add value to surrounding private land. If the government that owns the parks and gardens also taxes the value of the surrounding land, it has an incentive to preserve that value by preserving the parks and gardens.

It has been alleged that site valuations based on market transactions are imprecise because sales of bare sites are rare compared with sales of sites with buildings. This argument forgets that: (i) sometimes a property sale is promptly followed by demolition of the building(s), in which case the effective price paid for the bare site is the sale price plus the demolition cost; (ii) in the absence of significant boundaries, land value per unit area varies smoothly with location, allowing interpolations and consistency checks which are impossible with values of buildings; (iii) where necessary, the site value can be obtained by subtracting the value of the building(s); and (iv) a separate valuation of the building(s) is always needed for insurance purposes.

Descending from the fallacious to the ridiculous, it has been alleged that because the market value of a site is built up by developments on surrounding sites, taxing the said value deters the said developments. That the developments are generally done by parties other than the one paying the tax, and therefore cannot be discouraged by the tax, is not mentioned. "Ah," says the objector, "but if the same party develops a large cluster of sites, some of the uplift in the value of each site is due to work by the same party on the other sites in the cluster." So, because it is so iniquitous that site value taxation sometimes falls partly and accidentally on productive activities, we are told that we must prefer taxes that always fall entirely and deliberately on productive activities! When such obviously invalid arguments are offered in support of a policy, you know you're dealing with a hidden agenda.

1.6.1  The strange case of net annual value (NAV)

Under s.2 of Victoria's Valuation of Land Act, the capital-improved value (CIV) of a property is the lump-sum price that the property (including buildings and other improvements) would be expected to realize on outright sale, whereas the net annual value (NAV) is the annual rental value of the property (including buildings and other improvements) subject to the proviso that the NAV shall be at least 5% of the CIV for commercial and industrial property, and exactly 5% of the CIV for residential and agricultural property. In practice, the rental value of commercial and industrial property tends to exceed 5% of the CIV, with the result that the NAV is assessed as a higher percentage of the CIV for commercial and industrial property than for residential property. On that ground it is argued that NAV favours home owners over commercial and industrial property owners.

This argument, like all arguments about particular rating systems favouring particular interest groups, is moot in that our proposed implementation of site-value rating avoids any redistribution of the rate burden in the transition from the old system to the new: in any municipality that presently has NAV, our transition to site-value rating would preserve any bias in favour of residential property owners.

But is there any such bias? The following observations suggest not:

(1) Rezoning land from residential to commercial/industrial increases its site value; and the consequent increase in rates is greater under a pure site-value system than under NAV or CIV, both of which allow building values to dilute the rating base.

(2) The residential property owners most often alleged to suffer hardship due to municipal rates are:

(a) Owner-occupants of single dwellings on sites whose values have been raised by rezoning (e.g. for commercial use or higher-density residential use); and

(b) Owner-occupants of homesteads on farms whose values have been raised by the expectation of rezoning (e.g. for residential use).

Under s.3 of the Local Government Act, which refers to s.2 of the Valuation of Land Act, properties in categories (a) and (b) are respectively called residential use land and urban farm land. And under s.161A of the Local Government Act, a Council using NAV or site-value can relieve the alleged hardship by applying a differential rate to land in either of these categories.

Moreover, if the adoption of site-value rating increased the burden on residential sites, it would thereby increase pressure on the owners of unoccupied or underdeveloped residential sites to attract tenants or buyers, and would therefore make housing more affordable for renters and first-time buyers. To use this as an argument against site-value rating is to ignore the interests of renters and would-be buyers or, at best, to discount their interests relative to those of incumbent owners.

If, to the contrary, the adoption of site-value rating increased the burden on commercial or industrial sites, it would thereby increase pressure on the owners of unoccupied or underdeveloped commercial or industrial sites to attract tenants or buyers, and would therefore make accommodation more affordable for job-creating enterprises. Most of the beneficiaries of the additional job-creation, i.e. most of the affected employees, would also happen to be owners of residential property, and the rest would be renters of residential property.

Finally, "residential property" includes not only homes, but also vacant land held by speculators and land-banking developers. The inclusion of buildings in the rating base clearly harms the owners of buildings, including home owners and "mum and dad" property investors, relative to owners of vacant land.

For all these reasons, it is not at all clear that NAV favours residential property owners, let alone home owners; and the whole argument conveniently excludes the needs of renters, would-be buyers, and employees.

1.7  De facto building taxes

The construction or extension of buildings is deterred not only by the rating of building values, but also by any other property taxes that tend to increase with the quantity of accommodation. In Victoria, at the local level of government, such taxes may include water access charges and sewer access charges (both levied on a per-property basis, which presumably means a per-unit basis in a multi-unit complex), and garbage and recycling charges (which tend to be levied on bins according to number or capacity, and which therefore increase with the number of dwellings). Any volumetric charges, such as water-consumption tariffs or sewage-discharge tariffs, are excluded because they are not simply holding costs on property.

Per-dwelling taxes are defended on the ground that it costs the local government more to service a multi-unit complex than a single dwelling. But this is already taken into account by site-value rating, in that the mere permission to build more units on a site increases the site value.

We therefore contend that de facto building taxes imposed by local governments should, as far as possible, be rolled into site-value rating.

2.  Implementation with no losers

If all recurrent local property taxes are replaced by site-value rating in the simplest possible manner, with no change in overall revenue, ratepayers with below-average ratios of site value to building value — such as ordinary home owners, and owners of rental properties — will pay less, while those with above-average ratios — such as speculators holding vacant or derelict sites in anticipation of capital gains, and developers holding speculative "land banks" — will pay more. And those who pay more will punish the responsible legislators by all available means, including disinformation on the effects of the reform on other voters.

In Victoria, existing State legislation provides a solution in the form of the Municipal Charge (MC). By varying this charge from site to site, a Council can compensate for the gains and losses caused by the transition to site-value rating while still avoiding all the disadvantages of taxing buildings [subsection 1.4] and retaining the qualitative advantages of taxing sites [subsection 1.5]. The only disadvantage of such "compensation" is that the pressure to use sites productively (in order to cover the Rates bill) is not increased in respect of the site values existing at the time of transition, although it is increased in respect of subsequent unearned increments in site values.

2.1  How to set the Municipal Charge

To ensure that there are no losers in the transition to the new system, two conditions are sufficient. First, for each property, the total Rates bill for the first year of the new system (the "initial bill") is the same as the total bill for the last year of the old system. Second, the Rates bill in each subsequent year is

bill = initial bill + (rate × SV) − (initial rate × initial SV)

(1)

where

rate = marginal rate on site value for current year [%/year];
initial rate = marginal rate on site value for first year of new system;
SV = site value for current year;
initial SV = site value for first year of new system.

Notice that Eq.(1) is valid not only for "each subsequent year" but also for the first year of the new system, when the rate and the SV have their "initial" values.

Eq.(1) can be written

bill = MC + (rate × SV) ,

(2)

provided that

MC = initial bill − (initial rate × initial SV).

(3)

If we choose the "rate", Eq.(3) gives us the required Municipal Charge (MC) for each site. However, because of legislative restrictions on the MC, the choice of the "rate" is not completely arbitrary. Under s.159 of the Local Government Act, a Council's total revenue from the MC in any financial year must not exceed 25% of its total revenue from General Rates — or, as the Act says, 20% of its total revenue from the Municipal Charge plus General Rates [paragraph (2) of s.159]. Furthermore, as the stated purpose of the MC is "to cover some of the administrative costs of the Council" [paragraph (1)], it is arguable that the total revenue from the MC must be positive, even if the MCs for some sites are negative. Within these constraints, there seems to be nothing in the Act to prevent a Council from computing the MC according to Eq.(3).

Given that the fraction of revenue raised from General Rates (i.e. rate × SV) must be between 80% and 100%, and that SV rating is best, it would be reasonable to set the fraction at the high end of the range — say 98% — for the first year of the new system. Dividing the required General Rates revenue by the total SV then yields the "rate", which is substituted into Eq.(3) to obtain the MC for each site. As Eq.(3) implies, this MC does not change in subsequent years.

For a new site created under the new system (e.g. because of a new subdivision or an increase in building-height limits), the MC could be set at 2% of the first Rates bill for the site [Eq.(2)] and left at the same dollar value in subsequent years.

2.1.1  Example

Property A is a house-land package, while property B is a vacant lot whose zoning permits the construction of a two-storey block of flats. In the last year of the old system, property A is valued at $100,000 for the site plus $100,000 for the building, while property B is valued at $210,000. Under the old system, each property pays General Rates of 1% of the combined value, plus a Municipal Charge (MC) of $100, while property A pays a further $100 in fixed levies for water connection, sewerage connection, etc., which are not needed by the uninhabited property B. Under the new system, in order to ensure that the total revenue from the MC is within the permitted range, the Council chooses a marginal rate of 1.5% per annum on the site value. In the first three years of the new system, the values of the sites are as follows:

Year    Property A    Property B

  1      $108,000      $220,000
  2      $100,000      $210,000
  3      $110,000      $230,000.

Questions:

1. What is the total bill for each property for the last year of the old system?
2. What is the total bill for each property for the first year of the new system?
3. What is the MC for each property under the new system?
4. If the marginal rate remains constant, what is the total bill for each property for years 2 and 3?
5. If the marginal rate were reduced to 1.4% in year 3, what difference would that make to the two bills?
6. If, at the end of year 2, the owner of property A demolished the house while the owner of property B built a $220,000 block of units, what difference would that make to the two bills for year 3?

Answers:

1. Property A pays 1% of the combined value ($200,000), plus $100 for the MC and $100 in other levies, giving a total of $2200. Property B pays 1% of $210,000, plus $100 for the MC, which also comes to $2200.
2. $2200 apiece, i.e. the same as for the last year of the old system. (The next question is about how to rig the MC to achieve that outcome.)
3. For property A, Eq.(3) gives $2200 minus 1.5% of $108,000, which comes to $580. For property B, Eq.(3) gives $2200 minus 1.5% of $220,000, which comes to −$1100 (yes, a negative value).
4. For property A: In year 2, Eq.(2) gives $580 plus 1.5% of $100,000, which comes to $2080; and in year 3, it gives $580 plus 1.5% of $110,000, which comes to $2230. For property B: In year 2, Eq.(2) gives −$1100 plus 1.5% of $210,000, which comes to $2050; and in year 3, it gives −$1100 plus 1.5% of $230,000, which comes to $2350.
5. For property A, the result for year 3 becomes $580 plus 1.4% of $110,000; that makes $2120. For property B, the result for year 3 becomes −$1100 plus 1.4% of $230,000, which also comes to $2120. The effect of the rate reduction (0.1 percentage points) is to reduce the bill by $110 for property A and by $230 for property B (i.e. by 0.1% of the site value in each case).
6. No difference at all. That's the point!

Notice that between years 1 and 2, each bill falls by 1.5% of the reduction in the site value, and that between years 2 and 3, if there is no change in the marginal rate, each bill rises by 1.5% of the increase in the site value. In the latter case, for which the increases in the site values are in the ratio 1:2 ($10,000 for property A vs. $20,000 for property B), the increases in the bills are also in the ratio 1:2 ($150 vs. $300); but while the percentage increase in the site value for property B is less than for property A, the percentage increase in the bill for property B is more than twice that for property A, showing the effect of property B's high site value and negative MC.

2.1.2  Note on net annual value (NAV)

The above example assumes that the old system levies rates on the "combined value", i.e. the capital-improved value (CIV). If the old system used the net annual value (NAV) instead, the answer to question 1 would be affected, but the method used for questions 2 to 6 would stay the same.

2.2  Advantages of a fixed marginal rate

Recall that the first Rates bill under the new system would be the same as the last bill under the old system. According to Eq.(2), the bill for each successive year could rise or fall, depending on adjustments in the "rate".

However, if the "rate" (like the MC) remains fixed, any rise or fall in the site value will cause a proportional rise or fall in the Rates bill. Contrary to superficial appearances, this arrangement is beneficial to site owners not only when site values fall, but even when site values rise, because:

• your Rates bill doesn't rise unless your site value does; and a site value doesn't rise unless, in the judgment of the market, the owner is better off even with the higher Rates bill; and

• the Council gets an incentive to do things that increase site values — such as providing infrastructure.

The benefit of an infrastructure project is measured by the price that people are willing to pay for it. Part of that price is paid in user charges (e.g. fees, fares, tolls, volumetric charges), and the rest is paid in the rents and prices of locations that benefit from the project, as opposed to locations that don't. "Location, location!" And the locational value of a property is contained in the value of the site.

Therefore, if the benefit of an infrastructure project exceeds the cost, whatever part of the cost is not covered by user charges can be covered by taking back part of the uplift in site values. One mechanism for doing this is site-value rating with a fixed MC (per site) and a fixed marginal rate.

2.3  Asset-rich, income-poor ratepayers

Opponents of site-value taxation love to wheel out the "poor widow" who owns an appreciating home but has a fixed income, and who therefore may not have the cash flow to pay the rising Rates bill. Meanwhile the real poor widow, namely the widow who rents — especially if her rent is rising because the supply of homes is suppressed by taxation of buildings and undertaxation of sites — is strenuously ignored, the more so because her capacity to save during her younger days would have been greater under SV rating than under non-SV rating.

Of course the majority of people with appreciating homes and fixed incomes are neither poor nor widowed, but the "poor" home-owning widow makes the most emotive stereotype. And of course most of the same people would happily borrow against their rising asset values in order to pay for plasma TVs or overseas holidays, but woe to any Councillor who suggests that they do the same in order to pay the Rates! This "problem" is not confined to site-value rating; but site-value rating makes it particularly acute by deliberately targeting the appreciating component of the property.

The solution, if one is needed, is to let every residential owner-occupant defer payment of all or part of every increment in the Rates bill until the property is next sold or bequeathed, and, for added safety, to cap the deferred component to some legislated fraction of the real increase in the site value since acquisition. Councils already have sufficient legislative power to do these things under the "Deferred payment" and "Waiver" provisions of the Local Government Act [ss. 170, 171; see also ss. 142, 171A].

Contrary to superficial appearances, it would not be in the interests of ratepayers to make greater use of waivers, e.g. by simply waiving all increases in Rates bills above certain limits for certain classes of ratepayers, because that would reduce the fiscal incentive for the Council to do things that increase site values.

Opponents of site-value taxation also love to wail about the "family business" which has owned and occupied an appreciating site for decades, but which will be "forced to close" because it allegedly can't pay the Rates. But the reason why it "can't pay" is that the site, at its current value, is grossly underutilized. If the operators of this "business" were truly businesslike, they would either redevelop the site and let the excess space to tenants, or sell the site for a huge capital gain and relocate (or retire!). In either case, they would have no trouble paying the Rates.

The only family businesses forced to close by rising site values are those that rent their premises and can't afford the rising rents. But they, like widows in rented homes, are ignored because their rents would be more affordable under SV rating than under non-SV rating.

An economically efficient rating system does not allow prime sites to be wasted, nor does it indulge commercial property owners who want to make locational decisions on non-commercial criteria. An equitable rating system does not help the owner of an under-used commercial site, sitting on an obscene capital gain, to sit there even longer while the capital gain grows even more obscene. When the operators of a "family business" complain about this, they show that their real business is parasitic land speculation.

2.4  Infrastructure and housing affordability

Under site-value rating with a fixed MC (per site) and a fixed marginal rate, homes would rise in value due to investment in infrastructure. This however does not mean that the housing would become less affordable, because the rise in value would reflect greater amenity; it would not mean higher rents or prices for housing of given amenity. Moreover, "greater amenity" often takes the form of real cash savings, especially on transport costs.

The affordability of housing is a function not only of its rent or price, but also of its amenity and of the spending power of potential tenants and buyers. That's complicated. In contrast, the unaffordability of housing is expressed in a single variable, namely the intensity of the competition for housing — the competition that you must win in order to rent or buy a particular home. Site-value rating, or any other system whereby a government claws back part of the increase in site values, makes rental income more attractive relative to capital gains, and thereby gives property investors an incentive to build dwellings and offer them to let (or sell their sites). Furthermore site-value rating, unlike other systems of rating, avoids penalizing site owners for building. The ensuing increase in the supply of homes reduces the competitive pressure on prospective renters and buyers, and thereby makes housing more affordable.

There is a tendency to think of housing affordability as a zero-sum game in which the gains of renters and buyers are the losses of landlords and sellers. This view is too simplistic because it fails to allow for economic growth, which may be driven by, inter alia, construction of housing and investment in infrastructure. If a policy that improves the bargaining positions of renters and buyers is also conducive to growth — as site-value rating is — then all participants in the housing market can gain by sharing in the additional growth.

3.  Empirical evidence of the superiority of SV rating

In any other debate about taxation, it would be common ground that taxing a product reduces its production and all the effects that follow therefrom. The proposition is so simple, so reasonable, so commonplace, so confirmed by experience, and so often assumed as a foundation of policy, that to question it would be regarded not as skepticism but as folly or knavery. Applied to local rates, the proposition implies that the inclusion of building values in the rating base reduces the supply of buildings and all the economic activity that depends thereon. And yet, through most of the world (with notable exceptions including Queensland and NSW), local property taxes on the combined values of land and buildings are the norm, and it is the advocates of site-value rating who, if they are not simply ignored (as they usually are), are called upon to prove their case with hard data — and to prove it again and again.

So they do.

The so-called evidence against site-value rating can be quickly disposed of. If (say) Smithville adopts site-value rating, and if this causes a burst of construction yielding a generation of new buildings, there may be a subsequent dip in construction as those buildings serve out their economic lives, followed by a second, larger, broader "hump" in construction as those buildings become ripe for replacement with larger and more valuable buildings. Meanwhile, if Jonesville continues to tax buildings, and if this delays construction of new buildings, the mere passage of time will increase the optimal sizes and values of those buildings when they are eventually built. So if the researchers choose a "long-term" timeline that includes some delayed construction in Jonesville but excludes the second "hump" in Smithville, they may be able to claim that Smithville got an early payoff followed by a "long-term" slowdown, because what they call the "long term" is only a fraction (and an unrepresentative one) of the building life cycle. It seems that three studies of this sort were done in the early 1980s [4, p.22].

In contrast, the evidence in favour of site-value rating has grown so voluminous that only a small sample can be reported here.

3.1  Terminology of rating systems

At present, local Councils in Victoria must levy rates on one of three bases: (i) capital-improved value (CIV), which is the total market value of the property, including buildings and other improvements; (ii) net annual value (NAV), which is the notional annual rental value of the property, including buildings and other improvements; or (iii) site value (SV). Thus CIV and NAV include buildings in the rating base, while SV does not [3].

CIV was not allowed as a rating base until 1989. But from 1968 until 1989, Victorian Councils had the option of a composite rate, commonly called a "shandy", which raised half the revenue from SV and half from NAV (other proportions were permitted but never used). Some foreign jurisdictions have used a weighted sum or average of SV and CIV (also called a composite tax) or, equivalently, a lower rate on the building and a higher rate on the site (a two-rate or split-rate tax). These various hybrid systems also tax buildings, albeit less severely than CIV or NAV.

3.2  Camberwell, 1920s

In A History of Camberwell (Lothian Publishers, 1980, p.86), Geoffrey Blainey wrote:

A few hundred people owned large areas of cow paddock and market garden and vacant land and refused to sell them for housing partly because they believed the speculative value of the land would rise. Such people blocked Camberwell's growth and contributed little to its municipal revenue. At Camberwell junction and other shopping centres, owners of old wooden shops were paying smaller rates than the enterprising landlords who built expensive shops and attracted business to the centre. In residential streets, landlords who allowed houses to go unpainted paid smaller rates, while the landlord who improved his property and therefore the neighbourhood's appearance and land values was penalised for his enterprise with higher taxes. The reformers argued that a new method of municipal taxation would accelerate the pace of Camberwell's growth and improve the quality of the suburb. Calling for a referendum, they carried the poll after a fierce campaign... From 1922, the new method of taxation undoubtably forced many large landowners to release vacant land for house building...

In the five years prior to 1923, the total number of dwelling permits issued in Camberwell was 2051. In the following five years the number increased to 4373. Camberwell tops suburban building statistics until 1946 [4, pp. 8,12].

3.3  Hutchinson's zonal studies

Before the amalgamations imposed by the Kennett government, the Melbourne metropolitan area included a large number of municipalities with a variety of rating systems. Hence it was in Melbourne that A.R. Hutchinson, founding director of the Land Values Research Group [5], pioneered the technique of grouping the municipalities into zones and correlating tax policy with economic activity within each zone. His results were published in Melbourne in 1945, but also attracted attention in the USA [6].

Hutchinson divided the municipalities of greater Melbourne into six zones according to distance from the CBD. For the purpose of comparing rating systems, zones 1 to 3 were useless because they contained no SV jurisdictions. But each of zones 4 to 6 (the outer zones) contained a mixture of rating systems. In the years 1928–1942, the number of dwellings constructed per available acre was 50% higher in the SV-rating areas than in other areas for zone 4, and more than twice as high for each of zones 5 and 6. Extrapolating these figures, Hutchinson concluded that if all municipalities in greater Melbourne had used SV rating, the additional construction would have eliminated Victoria's housing shortage (then estimated at 40,000 dwellings).

In 1949 the Land Values Research Group published "Rising Municipal Costs: A Comparison of Relative Abilities of Alternative Rating Systems to Provide Increased Rate Yield". This was a survey of the per-acre increases in rate bases and yields for seven (then) outer suburban municipalities that used SV rating (site only) and ten that used NAV rating (site and buildings), over a 20-year period. The SV Councils were Brunswick, Coburg, Camberwell, Caulfield, Essendon, Oakleigh, and Sandringham. The NAV Councils were Brighton, Footscray, Hawthorn, Kew, Malvern, Northcote, Moorabbin, Preston, Williamstown, and Heidelberg. The per acre increase in total NAV was £85 for the SV Councils, and £57 for the NAV Councils [4, p.12]. In other words, the use of site-value rating was associated with greater gains in property values.

3.4  Other studies on Melbourne

Melbourne also provided opportunities for longitudinal studies as the voters of individual municipalities switched to or from SV rating ("to" being more common).

The American Institute of Economic Research conducted a study of building activity in Victoria from 1927 to 1951. All Councils that had changed from NAV to SV in the 1940s were shown to have experienced marked increases in building activity immediately after the rating change. In suburban areas, construction occurred preferentially in SV-rating municipalities [4, p.13].

Harry Gunnison Brown, another U.S. economist, reported as follows:

What was the state of building in South Melbourne, Australia, prior to and following the adoption ... of land value taxation, with buildings and other improvements tax-exempt?

In the first six months of 1965, under the newly adopted land value tax system, the value of new building permits was 2.4 times what it had averaged for the four preceding six-month periods. The expenditures for alterations and additions to houses were 2.5 times the average in the four preceding six-month periods. Alterations and improvements on commercial buildings were about 50 per cent greater than the average in the four preceding six-month periods. The total value of new office building construction was 4½ times the previous figure. And the value of construction permits for industrial buildings more than tripled [7].

Notwithstanding South Melbourne's experience, the nearby municipality of Caulfield switched from SV rating to composite rating in 1969-70. In Caulfield, the number of building permits issued for 1969–72 was 66% below the number for 1966–69 [8].

3.5  Comparisons between Australian States

Taking advantage of the fact that some Australian States mandated SV rating while others did not, Hutchinson made interstate comparisons of construction rates (for 1921–33) and ratios of improvement values to land values (for 1939–40), and found that both measures were superior in the SV States. He also noted that there was a net interstate migration into SV States between 1929 and 1938, indicating that prospects in those States were perceived as superior [6].

In 1963 the Land Values Research Group published a "A Study of the effects of local government rating systems upon the social and economic development of the Australian states". From that study comes the following table [4, pp. 14–15], showing the change in acreage under crops in mostly SV-rating States and mostly NAV-rating States during two time intervals, one before the war and one after (during the war years agriculture was under government direction).

1929–1938		1946–1958
SV rating	NAV rating	SV rating	NAV rating
Qld   +66% NSW   +22% WA     +3% Total +21%	SA    -5% Vic  -10% Tas   -8% Total -8%	Qld   +76% NSW    +5% WA    +71% Total +35%	SA    +7% Vic   -6% Tas   -6% Total -1%

Notice that those states which had greater use of site value had greater increases in the acreage being used for crops. In other words, where site-value rating applied, farmers were encouraged to put the land to use.

3.6  South African experience

The following table shows the growth in the value of improvements on land between 1974 and 1984 (right column) for various rating bases (left column) for 48 South African towns [9]. The middle column shows the number of towns with each rating base.

Tax base    No. towns   Growth

CIV             2        189%
Composite      13        282%
SV             33        413%

The two "towns" with CIV rating were Cape Town and Port Elizabeth. Both had the advantage of being ports, and Cape Town had the added advantage of being the national and provincial capital. But, as the table shows, their ten-year growth in the value of improvements was less than half that of the SV towns.

3.7  North American experience

Steven B. Cord [10] overviews 237 studies of rating systems, saying in part:

45 studies conclude that when a town adopts land rent taxation, a spurt in new construction and renovation results.

63 studies conclude that towns switching from taxing buildings to taxing land always out-constructed and outrenovated their comparable neighbors who were subject to the same economic-growth influences....

30 studies concluded that LRT [land rent taxation] had various miscellaneous advantages — for example, tax defaults decreased....

Prof. Cord then gives some more details on 22 of those studies. His references to "two-rate" taxes are by comparison with "one-rate" taxes on the combined values of land and buildings, not with pure site-value rating (which is very rare in the USA). Again we quote him:

(2) Washington and nearby Monessen (both in southwestern Pennsylvania) are roughly comparable as to size and economy. After Washington shifted some of its tax off buildings onto land in 1985, its new private construction and renovation increased by 33% in dollar value in the three years after its two-rate adoption as compared to the prior three years. During the same time period, nearby one-rate Monessen's new private construction and renovation decreased by 26%....

(3) Connellsville, Pa. saw its new private construction and renovation jump 3.46 times in the three years after it adopted a two-rate LRT property tax as compared to the prior three years. This jump can be compared to the rather modest 1.07 increase in nearby Uniontown's new private construction and renovation during the same time period. The two cities are quite comparable, although Uniontown is somewhat larger and is the county seat (both are economic-development plusses)....

(7) .... After Pittsburgh increased its land-tax rate (but not its building tax rate) in 1979 and again in 1980, its construction increased fully 6.2 times faster than U.S. construction during the same period of time....

(10) In 1995, Professor Nicolaus Tideman of Virginia Tech University and his then-graduate student, Florenz Plassmann (now a professor at the University of Binghamton), completed a highly technical study of land value taxation in Pennsylvania entitled "A Markov Chain Monte Carlo Analysis of the Effect of Two-Rate Property Taxes on Construction." See ... Journal of Urban Economics, 3/00, pp. 216-47...

To quote from their conclusion:

"The results say that for all four categories of construction, an increase in the effective tax differential is associated with an increase in the average value per permit. In the case of residential housing, a 1% increase in the effective tax differential is associated with a 12% increase in the average value per unit..."

(21) A city-funded 1980 study in New Castle, Pa. revealed that seven vacant and two poorly developed downtown sites would be an estimated $150,851 more profitable to build upon with an LRT-only property tax. If county and school taxes were also to adopt LRT-only, then the extra profit would be an estimated $243,750 a year....

Finally he gives an example of backsliding and its consequences:

The city of Pittsburgh was taxing land assessments more than building assessments ever since 1915.... [I]n 2000, the voters in Pittsburgh were aroused to fever pitch... because their new land assessments were increased by five-to-eight times overnight.... So they pressured their city council to equalize the property-tax rates on land and buildings. This is what happened:

Pittsburgh experienced a 19.57% decline in private new construction and renovation in the three years after rescission as compared to the three years before, even though during the same time period, the value of construction put in place nationwide (which included public construction) increased 7.7% and sales tax receipts in Pittsburgh increased 7.6%. Both of these increases should have boosted Pittsburgh's new construction, but they didn't.

3.8  The people have spoken (and been Jeffed)

In the years 1920 to 1986, there were 90 plebiscites in which the ratepayers of various Victorian municipalities had the opportunity to choose between two rating systems. Some municipalities had more than one plebiscite over that period, and many had none. In 70 out of 90 plebiscites, the voters chose site value [4, pp. 33–36]. By 1993, the breakdown of rating systems was as shown in the following table [4, p.4].

Region	SV	NAV	CIV	shandy	Total
Metropolitan:	26	27	1	1	55
Provincial:	21	23	–	–	44
Rural:	8	92	11	–	111
Total:	55	142	12	1	210

Note the low take-up of CIV since 1989. But the same report in which the above table first appeared [Rates: Proposals To Improve [sic] Victoria's Municipal Rating System, Office of Local Government, 1993] recommended that all newly amalgamated Councils adopt CIV. By 1996 there were 6 councils on NAV, 8 on SV, and 64 on CIV. Furthermore, under s.161 of the Local Government Act 1989, Councils could apply an unlimited number of differential rates if, and only if, they rated on the CIV. [On the limited differential rates under NAV and SV [s.161A], see part 1.6.1 above.] Thus councils were pressured to adopt CIV rating in order to be free to buy the votes of particular classes of land users. The pressure was not so strong for NAV councils, because the NAV was fixed at 5% of the CIV for residential properties but could be higher for commercial and industrial properties, thus giving a de facto differential in favour of the more numerous residential ratepayers. But SV councils gradually succumbed to the pressure. Worse, while the 1989 Act took away the right of ratepayers to initiate a change in the rating system, subsequent amendments took away even the right to demand a plebiscite reversing a change initiated by the council.

Today, the only Melbourne municipality that retains SV rating is Monash. In Prosperity for the Next Generation (2001), the Monash City Council boasted:

Monash has the largest number of both businesses and jobs among the 11 municipalities. It performs a key role in providing employment to people living in other parts of the region, particularly in the newly established and growing suburbs of the outer south-east.

As a result, of all the 11 municipalities, Monash is the most influential provider of household disposable income to residents in neighbouring municipalities. Unlike some municipalities that provide jobs and therefore household income primarily to their own residents, Monash is a key provider of income to the residents of Greater Dandenong, Casey, Knox, Cardinia, and Kingston. There is a high level of interdependency between Monash and the other 10 municipalities in the region. Not only is it an important jobs hub, but Monash also is a major generator of wealth in the region. After Kingston, it has the highest export output per capita of all municipalities in the region. It also is the least dependent local government area in the region on government transfer payments to residents, indicating on average a high degree of employment and wealth among its residents.

4.  Conclusion

In any Australian State, the implementation of site-value rating, with no de facto building taxes and no losers, could be imposed top-down by the State Parliament. But in Victoria, each municipality could implement such a reform by itself, achieving the "no losers" feature by suitably calculating the Municipal Charge permitted by the Local Government Act.

We submit that if it was good enough for the Cain and Kennett governments to impose by stealth a rating system that was overwhelmingly rejected by voters for two thirds of a century, it is good enough for the present Victorian Councils to adopt the system that the voters tended to endorse when given the chance: site value. Even more clearly, it is good enough for candidates in the upcoming Victorian local elections to campaign on a policy of introducing or re-introducing site-value rating.

If the transition to site-value rating were to be done with no losers, as proposed here, obtaining a mandate for it should not be difficult. The headline promise would be to stop penalizing ratepayers for building, rebuilding, extending, and renovating. The one-sentence explanation would be that your Rates bill for the first year of the new system will be the same as in the last year of the old system, whereas in subsequent years changes in your Rates bill will depend solely on changes in your site value, not the value of any buildings. It would be obvious that such a policy would increase the supply of buildings, making accommodation more affordable and creating jobs not only in construction, but also upstream and downstream. It would be equally obvious that the increase in the supply of accommodation would be disinflationary, and almost as obvious that reduced inflationary pressures would allow higher speed limits on job creation and economic growth.

Notes