Replacing property taxes and payroll tax

A submission by the Land Values Research Group*
to the State Tax Review
(Dept. of Treasury & Finance, Tasmania)

Abstract

The revenue from payroll tax, property transfer duty, insurance duty (largely passed on to property owners) and the existing land tax could be replaced by a broad-based “land tax”, with no exemptions or thresholds, at a flat rate of about 1.5% per annum, which happens to be the top marginal rate of the existing land tax.

Alternatively, the same revenue could be replaced by a property-vendor duty levied on the real increase in the land value since the last sale, at a rate of about 45%. The new duty, unlike the existing purchaser duty, would never turn a profitable purchase-and-resale into a loss or magnify a loss.

Under the “land tax” option, owners who were exempt from the old land tax, or who are otherwise deemed to have cash-flow difficulties, could be allowed to defer payment, at an interest rate equal to the State Government's borrowing rate, until the land is next sold; and the deferred liability could be capped at some fraction of the real increase in the land value since the last sale, that fraction being higher than the aforesaid 45% to compensate for the delay and encourage early payment.

Either option would (i) create jobs by reducing taxation of labour and its products, (ii) encourage construction by reducing taxation of buildings, and (iii) make new infrastructure pay for itself through the ensuing uplifts in land values.

Contents

1.  Some seldom-explained principles

It seems obvious that “if you tax something, you get less of it.” Indeed, if you tax employment — e.g. through payroll tax — you get fewer jobs, lower-paying jobs, and lower production (and higher prices) of goods and services embodying labour. If you tax values of buildings — e.g. through property transfer duty, or insurance duty as applied to building insurance, or municipal rates on capital values (CVs) or assessed annual values (AAVs), or charges for services correlated with the presence of buildings — you get fewer and inferior buildings, hence unaffordable accommodation. If you tax property transfers, you get fewer transfers, including fewer of those transfers that are needed to bring new accommodation to market, so that affordability is further damaged.^†

But if you impose a holding charge on the value of land (e.g. “land tax” and land-value rating), you cannot get less land or inferior land, because the supply of land is fixed, while its value is not created by the party who pays the tax thereon. Moreover, the holding charge improves the availability of the given land supply for productive purposes, because the owners must generate income from the land in order to cover the holding cost — or sell it to someone who will. Land is opened up for construction. Hence employers can more easily afford business accommodation, while employees can more easily afford housing within commuting distance of their jobs out of wages that their employers can afford. Economic activity increases.

A borderline case is a property transfer duty payable by the vendor and proportional to the real increase in the land value since the last sale. In this case the transfer does not create the tax liability, but merely realizes a liability that has accumulated during the period of ownership. If a property changes hands more frequently, it does not contribute proportionally more tax, but contributes in a larger number of smaller instalments. Such a duty resembles a holding charge whose payment is deferred until the most convenient time, namely when the property is sold. For these reasons, a duty payable by the vendor on the increase in the land value since the last sale has less lock-in effect per dollar of revenue than a duty payable by the buyer on the purchase price [1].

A vendor duty on the increase in the land value does not force the owner to generate income simply to cover a holding cost; but it cuts into the capital gain and therefore, by default, increases the importance of current income.

Whether a transfer duty is nominally payable by the vendor or by the purchaser is an administrative matter, having no effect on the ultimate distribution of the burden. If the duty is payable by the seller, the seller will try to add it to the price. If it is payable by the buyer, the buyer will try to subtract it from the price. In the end, the duty will be shared between the two in inverse proportion to their bargaining powers, regardless of which party actually forwards it to the Treasury. But if the duty is levied on the real increase in the land value since the last sale, it is convenient to make it payable by the seller, who already knows (or should know) the base value on which the dutiable increase will be calculated.

Moreover, even if the nominal incidence of a transfer duty (on the buyer or the seller) were the same as the economic incidence, that would hardly matter to a person who buys one property and sells another. What matters to that person is the total bill, not its distribution between the two transactions.

The truism that “if you tax something, you get less of it” applies to activities of the private sector (e.g. employment, construction, property transfers). It does not apply to works of nature (e.g. land). Even less does it apply to activities of the government imposing the tax.

If the government gets a clawback from increases in land values, either through “land tax” or through a vendor duty, it has an incentive to do things that cause such increases. In particular, it has an incentive to invest in infrastructure, whose benefit (net of user charges such as fares and tolls) is manifested in the prices of access to locations serviced by the infrastructure — that is, as an uplift in land values. If the benefit (net of user charges) exceeds the cost (also net of user charges), the cost can be covered by clawing back a sufficient fraction of the uplift. The rest of the uplift is a net windfall to the land owners — a windfall which they might not otherwise get, because the infrastructure might not otherwise be funded.

If the clawback takes the form of a vendor duty, land owners can't lose: if they don't get a windfall, they don't pay the clawback. If the clawback is effected through “land tax”, owners still can't lose through increases in their land values, because their tax bills don't rise unless their land values do, and the land values don't rise unless, in the judgment of the market, the owners are better off in spite of the tax implication.

Financing infrastructure through uplifts in land values does not require a tax increase in order to pay for the infrastructure. Rather, it requires a change in the tax mix, so that future investment in infrastructure pays for itself by expanding the revenue base without any increases in tax rates. The initial change can be revenue-neutral.

Uplifts in land values due to infrastructure do not damage affordability, because they reflect improving utility, not worsening scarcity; they do not represent higher prices or rents for land of the same utility.

2.  Numerical estimates

If you tax gambling and vehicle ownership, you get less gambling and vehicle ownership. As that outcome might be alleged to be desirable, let us ignore gambling and motor taxes and concentrate on replacing or subsuming payroll tax, property transfer duty, insurance duty and the existing land tax. The total revenue expected from those four taxes in 2010-11, according to the Budget estimates as quoted in the discussion paper [2], comes to $576.7 million.

Suppose that the desired revenue is to be raised by a flat “land tax” with no exemptions or thresholds. The discussion paper gives the total value of land in Tasmania as $39,084 million [3]. By way of comparison, the Australian Bureau of Statistics gives a total value, excluding the small “other” category, of $38,400 million for mid 2009 [4]. Using the slightly more conservative ABS valuation, we find that the required “land tax” rate is 1.5% per annum — which happens to be the current top marginal rate, albeit with no exemptions or thresholds.

Alternatively, suppose that the same revenue is to be replaced by a vendor duty on the real increase in the land value since the last sale. There are 218,000 properties in Tasmania, of which 20,715 properties, i.e. 9.5%, changed hands in 2009-10 [5]. Assuming that the same fraction of the land value changed hands, we estimate that $3649 million worth of land was sold that year. The ABS has recorded the total value of land in Tasmania on June 30 of each year from 1989 to 2010. Dividing these values by the national CPI and assuming an 18-year cycle in the land market, we find that the average real rate of increase in land values through the cycle is, conservatively, 6.5% per annum [6]. Assuming, further, that the land sold in a year has been held for 7 years, during which it has appreciated at the average rate, we find that the taxable “capital gain” is $1301 million, requiring a tax rate of 44.3% or, in round figures, 45%.

At the cost of a slight increase in the vendor-stamp-duty rate, federal capital-gains tax could be deductible against the dutiable increase in value.^‡

3.  Cruel to be kind

In so far as the present exemptions from land tax are motivated by the concern that certain property owners lack the cash flow to pay a holding charge, that concern would be adequately addressed by deferring the payment until the owner does have the cash flow — namely when the property is sold — and capping the deferred liability to ensure that it is easily payable out of the net proceeds of the sale. This is true whether the exemption applies to a certain class of owners (e.g. residential owner-occupants) or to part of the land value (the “threshold”).

Granting an exemption instead of a deferral may seem kind to the land owner. But this kindness comes at a terrible price — namely payroll tax, property transfer duty and insurance duty. Even if the land-tax exemptions leave land owners better off in their capacity as land owners, the other taxes leave them worse off in other capacities, and hence possibly worse off overall. Furthermore, it is by no means clear that land owners are better off even in their capacity as land owners, because the other taxes, together with their deadweight costs, reduce capacity to pay for land and therefore bear down on land values. John Locke put it this way:

It is in vain in a country whose great fund is land to hope to lay the publick charge of the Government on anything else; there at last it will terminate. The merchant (do what you can) will not bear it, the labourer cannot, and therefore the landholder must: and whether he were best to do it by laying it directly where it will at last settle, or by letting it come to him by the sinking of his rents, ... let him consider [7].

Moreover, as noted above, the failure to capture uplifts in land values reduces the capacity of governments to finance infrastructure that causes such uplifts.

Where a land-tax exemption is given to a religious, charitable or educational institution, one must ask whether the exemption should continue to apply when that institution no longer merely owns and occupies real estate for its worthy purposes, but buys and sells real estate at a profit — bearing in mind that buying and selling a fixed stock of land is a zero-sum game, in which every profit is someone else's loss.

Accordingly we submit that if the flat, broad-based 1.5% “land tax” is tempered by any concessions, those concessions should take the form of deferring payment until the land is next sold, and capping the deferred liability to some fraction of the real increase in the land value since the last sale.

The calculation of the vendor-duty rate might seem to imply that if all payments were deferred in this way, the required “fraction” would need to be about 45%. However, that calculation assumes that the vendor duty starts immediately in its own right. If it were a deferred payment of something else, the rate would need to be higher in order to compensate for the delay. Interest on the deferred payment would not always be sufficient compensation, because the cap would take precedence over the interest.

4.  Political precautions

If the deferred component of the “land tax” were below the cap, the logical interest rate for that component would be the government's borrowing rate. For political purposes, however, the interest rate would probably be less important than the cap, because the cap would represent the worst case for the land owner.

Lest the deferred “land tax” be branded a “death tax”, it should be payable when the land is next sold, not when it is merely inherited. That is, if land is inherited in a certain year and sold in a later year, any unpaid “land tax” liability that has accumulated before or after the inheritance should not become payable until the later year.

Similar comments apply if the vendor duty is imposed in its own right. If land is bought in year X, bequeathed in year Y, and sold in year Z, the duty should be payable in year Z on the real increase in the land value since year X. Thus the change of ownership due to the death of the original purchaser would not be a taxable event and would have no effect on the final tax bill.

The existing land tax is a frequent target of hostile headlines about large increases in bills, followed by reports that hide or downplay the much larger land-value windfalls that give rise to the said bills. The media take particular delight in reporting those cases in which the lease contract makes the land tax payable by a commercial tenant, who cannot pay the higher bill. The tenant cannot pay because the landlord has not developed the site to an extent commensurate with its value, and the underdeveloped state of the property restricts the tenant's earning capacity. Of course, each time the lease is re-negotiated, any land tax payable by the tenant instead of the landlord reduces the negotiated rent by the same amount. But when the tenant has been locked in to the lease, unexpected increases in land tax during the term of the lease can ruin the tenant. Needless to say, in this situation the landlords and the media blame the land tax itself, and not the laws that allow landlords to make tenants responsible for the bill.

For these reasons, contractual terms that make “land tax” payable by commercial tenant(s) should be outlawed unless the contract also allows the tenant(s) to redevelop the site and retain ownership of the new improvements. In the absence of such contractual terms, market forces do not allow the landlord to shift the “land tax” onto the tenant. Sales tax is a cost of selling and can be avoided by refusing to sell if the buyer does not offer a sufficient price to cover the tax. So sales tax can be passed on in the price. But “land tax” is not a cost of letting and cannot be avoided by refusing to let; rather, it is a cost of owning the land, and makes letting the land all the more necessary in order to obtain income to cover the “tax”.

Even if large increases in “land tax” bills cease to be a problem for tenants, they will still provoke adverse headlines. The present causes of large increases in bills are:

1. the long period between valuations, hence large differences between consecutive valuations;
2. thresholds and progressive rates, which cause increases in tax bills to be larger, in percentage terms, than increases in land values;
3. bubbles — i.e. rapid rises in market values, driven by expectations of capital gains rather than rental income.

The respective remedies are:

1. more frequent valuations;
2. a flat rate with no threshold, as proposed in this submission;
3. broadening the base of the “land tax” and applying the top marginal rate across the board, thus applying stronger negative feedback to the market: when values rise, holding costs also rise, making it more attractive to sell and less attractive to buy (and when values fall, holding costs also fall, making it less attractive to sell and more attractive to buy).

More frequent valuations for “land tax” purposes would require savings in valuation services used for other purposes. Those savings could be achieved by mandating land-value rating for all local councils, so that valuers do not waste time assessing CVs and AAVs [8]. Of the three rating bases used in Tasmania, the land value (LV) is the least labour-intensive to assess, for the following reasons:

• Capital works (building, rebuilding, extension, renovation) no longer require supplementary valuations;

• As LV is the location-dependent component of CV, one cannot assess CV without at least implicitly assessing LV;

• LV, unlike CV or AAV, is subject to spatial continuity: between significant boundaries, the LV per unit area is a smooth function of location; hence LVs, unlike CVs and AAVs, can be obtained by interpolating between sites for which good data are available.

Valuers obtain especially “good data” when someone buys a site with an existing building and promptly demolishes the building: the purchase price plus the demolition cost is the effective price paid for the bare land. That is one reason why, contrary to myth, the comparative rarity of sales of vacant lots in established suburbs is not a major impediment to the accurate valuation of land.

5.  Conclusion

Public inquiries into tax reform tend to conclude that replacing conventional taxes with a broad-based holding charge on land values is economically desirable but politically difficult. We submit that the political difficulties are overrated. The objection that some land owners have limited cash flow is adequately addressed by deferrals, with caps on deferred liabilities. Adverse headlines about large increases in bills can be minimized by frequent valuations, a flat rate with no thresholds, and a rate high enough, on a base broad enough, to prevent land-price bubbles.

If that is still deemed to be too difficult, one can obtain some of the benefits of the broad-based holding charge by means of a property-vendor duty proportional to the real increase in the land value since the last sale.

Either of these options can deliver large political dividends through the elimination of payroll tax, the property transfer duty on purchasers, and insurance taxes.

Notes

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