State capital-gains tax would pay for infrastructure and enrich property owners without fleecing the rest of us

By Gavin R. Putland

The benefit of a new or improved transport route, net of fares or tolls paid for actual use, is shown in prices of access to locations where that benefit is available — in other words, land values. The affected locations include those serviced by the new or improved route, or by other routes on which congestion is reduced by the new or improved route. So the beneficiaries of any extension or improvement of the transport network include not only the users, but also the affected property owners.

The same principle applies to other types of infrastructure to the extent that their benefits are location-dependent. Examples include schools, hospitals, emergency services, water, sewerage, drainage, electricity, gas, and communications.

One might therefore suggest that property owners should give back some of the benefits through a levy on unearned increments in land values. Paradoxically, such a levy would make property owners better off than they are now. If the responsible government receives a certain fraction of every unearned increment, infrastructure projects whose cost/benefit ratios are less than that fraction will be profitable for the government and will therefore proceed. The profits can be used to reduce other taxes or to fund other projects (just in case those hospitals don't quite pay for themselves through uplifts in land values). Property owners will be winners because they will reap land-value windfalls that they would not otherwise get, due to projects that would not otherwise be funded.

In Australia the government most directly responsible for infrastructure is usually the State government, which can claw back unearned increments through the taxation power. In contrast, private funders of infrastructure are usually not in a position to recover any substantial share of the unearned increments.

That said, implementation of this funding mechanism does not require an increase in taxation. It requires a one-off change in the tax base so that future investment in infrastructure pays for itself by expanding the tax base without any increase in tax rates. The initial change in the base can be revenue-neutral. For example, a range of inefficient or unpopular State taxes — including conveyancing stamp duty, developer contributions for infrastructure, insurance taxes (largely paid by property owners), land tax on occupied land, and preferably payroll tax — could be replaced by a State capital-gains tax (CGT) on property. The rate of the State CGT might then be in the “sweet spot”: high enough to drive infrastructure investment at full capacity, but low enough to leave property owners with an attractive slice of the benefit.

And what rate would that be? By my estimates, about 45% on the real (inflation-adjusted) capital gain, leaving 55% of the benefit with the property owners. That 55% would be an unearned windfall for the property owners. In the case of a windfall caused by infrastructure, the property owners would probably not otherwise receive it, because the infrastructure would probably not otherwise be funded. Federal CGT (if applicable) would treat the State CGT as a resale cost to be deducted from the taxable capital gain.

Under a State CGT, the State government would receive a revenue increase for each well-chosen project that it funds, and the increase would automatically come from the owners of properties that rise in value due to the project. Of course the State government would also receive revenue from owners of properties that rise in value for other reasons. That is no injustice to the owners, for whom the rise would still be an unearned windfall. Thus the infrastructure would be funded out of uplifts in land values due to the infrastructure, while the replacement of old taxes would be funded out of uplifts in land values due to other causes (and any surplus from the infrastructure-induced uplifts).

Affordable amenity

Would these uplifts in property values damage affordability of housing? No, for four reasons:

(1) The uplifts would represent improved amenity, not higher rents or prices for the same amenity. Moreover, improved amenity translates into real savings for prospective tenants and buyers; for example, improved public transport may let a household get by without a car, or with one car instead of two, while a nearby school or hospital may reduce the need for transport.

(2) Landlords would receive the uplifts in the form of rents and capital gains, but the State CGT would tax only the capital gains, making rents more attractive. Thus property investors would be more inclined to build accommodation and seek tenants. This in turn would strengthen the bargaining positions of prospective tenants.

(3) If land tax were reduced to a tax on unoccupied land — including land with vacant buildings — it would strengthen the incentive for land owners to keep their properties built up and tenanted (or sell them to someone who will). This would further strengthen the bargaining positions of tenants (and prospective buyers). It would also neutralize the most effective arguments against land tax, because these arguments, be they valid or invalid, concern alleged adverse effects on tenants and owner-occupants — who, by definition, do not exist in the case of unoccupied land.

(4) Of all the ways of taxing property, the least onerous for first-time buyers is a capital-gains tax, which is payable only on the eventual resale, and only if the seller actually receives a capital gain from which to pay the tax. (The most onerous, of course, is a stamp duty on the initial purchase.)

There is no contradiction in the claim that both land owners and non-owners can be winners, because the size of the economic “pie” is not fixed. Investment in infrastructure is a method of making a bigger pie so that everyone can have a bigger slice.

Transitional provisions

It would be possible to apply the State CGT only to resales of properties acquired after the date of introduction of the duty (the “transition date”). But that would not be in the interests of property owners, because it would delay the public revenue stream that pays for infrastructure that causes uplifts in property values. If the infrastructure-induced uplifts are to begin immediately, they must immediately contribute to the public revenue. The question, then, is how to apply the State CGT to a property which was acquired before, but resold after, the transition date.

At first, let us suppose that the State CGT simply applies to all properties resold after the transition date, with the proviso that any stamp duty paid on acquisition is part of the cost base, to be adjusted for inflation for the purpose of computing the taxable capital gain. Let us further suppose that property owners are given ample warning of the transition date, so that they can decide whether to sell properties before that date in order to avoid the duty. Should they sell early? On the one hand, if they retain their properties after the transition date, they will be liable for State CGT when they eventually sell. On the other hand, the abolition of the old taxes, with their flow-on effects, will enable owners to get better resale prices after the transition date than before, and further delay can be expected to yield further gains as infrastructure projects are announced and delivered.

In short, the problem is not serious. If the duty applies to properties acquired before the transition date (“retrospectively”, as some would say), it is not clear that the owners are any worse off. In any case, if the owners are given ample warning of the transition date, they can plan their affairs accordingly.

If that is deemed not to be good enough, the CGT can be scaled back so that it does not replace payroll tax, but only replaces stamp duty, developer contributions, property-insurance taxes, and land tax on occupied land, all of which are paid directly by property owners. If you're a property owner, it's better for you (or your heirs) to pay CGT on your next sale only if you make a capital gain than to pay stamp duty on the next purchase (and other taxes in the mean time) whether you made a capital gain or not. Thus the alleged ”retrospectivity” works in your favour by providing a hedge. If that is still not good enough, the seller can be given the option of paying the stamp duty that would have been payable at the transition date, plus the CGT on the rise in value since then.

But I submit that such a scaling-back of the CGT would not be in the interests of property owners, because it would reduce the range of infrastructure projects that would become self-funding, and because the retained payroll tax would continue to be passed on through some combination of higher consumer prices, lower wages, fewer jobs and lower profits, all of which reduce the capacity to pay rent and service mortgages, and therefore reduce property values!

Automatic hypothecation

It is well known that voters are more likely to approve a tax increase if the extra revenue is reserved (“hypothecated”) for something that the voters want. NSW premier Mike Baird has skilfully exploited this fact by proposing to increase the GST in order to fund increased spending on public hospitals. Some other premiers have responded in kind, proposing to increase the Medicare levy (an income-tax surcharge) instead. But, as noted above, it is not necessary to fund the full cost of public hospitals out of statewide or nationwide taxes, because hospitals are among the forms of infrastructure that can be party or entirely funded out of the uplifts in land values that they cause.

A tax on windfall gains in the value of your land, by definition, is hypothecated on things that cause such gains. The hypothecation does not depend on politicians' promises, but is automatic: you don't pay the tax unless and until you get the windfall.

Beat that, Mr Baird.

[First posted 21 October 2013. Expanded 23 & 26 July 2015,  31 December 2015. Last modified 1 January 2016.]