How Victoria should tax property

Many may be surprised to learn that Victoria has a land tax on the books. However, the low rates mean the revenue raised is far from substantial, and the numerous exemptions, not least of which is that of the primary residence, mean that the supposed efficiency gains from the tax are compromised.

The idea of a tax on the unimproved value of land is not new. Adam Smith was the first to note the efficiency of such a mechanism in his hugely influential 1776 work, The Wealth of Nations. Contemporary advocates of a land value tax most often cite Henry George’s 1879 work Progress and Poverty as an illustration of the benefit it can bring.

The best assessment of whether or not a particular tax is a good or bad idea is its distortionary impact. That is, to what degree does it alter production decisions? Efficient taxes are regarded as those which do this the least. A land value tax has the unique characteristic of targeting a good that is not produced, but rather simply exists in a fixed and known quantity, so a land value tax cannot distort its supply.

In fact, the tax actually encourages the productive use of land. Because only the value of the land is taxed and not anything built on it, this act as an incentive for landowners to ensure the land is made as productive as possible. Maintaining and improving the property adds tax-free value that offsets the burden of the land value tax.

This incentive has the flow-on effect of reducing urban sprawl – a benefit particularly pertinent to cities like Melbourne. Because a land tax acts as an incentive for owners of valuable inner-city land to make their land as productive as possible, this leads to better and higher-density housing in prime areas, and therefore reduces pressure on outer-urban development.

Furthermore, it can dampen excessive property speculation. An appropriately set tax rate would make investing in property less attractive relative to other investment options. This would cool the overheating property market, and make life easier for first home buyers, as well funnelling investment into the creation of new, more productive assets, such as capital equipment and intellectual property.

Another, albeit more normative argument in favour of a land tax is that it has been found to be naturally progressive. Because rich individuals tend to store significant amounts of their wealth in land, the tax incidence falls disproportionately on the higher brackets.

However, one of the strongest arguments in favour of a land value tax was that championed by Henry George – the public cost recovery property. Investment in services and infrastructure by government increases the value of the surrounding land. This in turn increases the tax paid by the owners of that land. Therefore, a land value tax can help governments recoup the costs of public investment. And furthermore, it helps put the cost burden on those who are benefitting the most from the investment; an ostensibly fair and efficient outcome.

To see why this is an area in need of reform, consider that the low rates and critical exemptions meant that in 2013-14, the land value tax raised only about $1.6b for the state government. Contrast this to the $4.2b raised from stamp duty.

Stamp duty is inefficient because it discourages transfers of property, meaning it acts as a barrier to ensuring that property is allocated to those who value it most. For example, older individuals are discouraged from down-sizing, which hurts first home buyers who are faced with scarcer supply of suitable housing.

It should be no surprise that the Henry Review called for the abolition of stamp duty and better use of land value taxation. It speaks to the potency of the idea that ideologically opposed Nobel laureates Joseph Stiglitz and Milton Friedman have both endorsed the idea.

There are, however, barriers to this twin policy in the form of political realities. People are not likely to be thankful enough for the abolition of a fee on a transaction they rarely make – at least, not thankful enough to make up for the dissatisfaction of paying tax on valuable land that they thought was theirs to enjoy.