Poor governance is the dirty secret buried beneath increased land tax, argues IPA Adjunct Fellow Sinclair Davidson.
Over the past two years, the Victorian government has significantly restructured land tax, targeting property owners and landlords. These changes are a not-so-thinly veiled attempt to plug budget shortfalls exacerbated by the government’s overreaction to the COVID-19 pandemic and reckless infrastructure spending. The tax-free threshold for land tax, previously set at $300,000, has been slashed to $50,000 as of January 1, 2024. This reduction will catch many small-scale property owners who were previously exempt. The effect is simple: more Victorians paying tax, even on modest property holdings. In a further blow to property owners, land tax rates on higher-valued land have been increased across the board. For land valued between $300,000 and $600,000, the rate jumps from 0.2 per cent to 0.3 per cent. For land valued between $600,000 and $1,000,000, it rises from 0.5 per cent to 0.6 per cent. This progressive structure does not just ‘tax the rich’; it imposes heavier burdens on anyone with a relatively substantial investment in property, regardless of their capacity to bear these additional costs.
But there is more. The government has introduced a so-called COVID Debt Levy, a temporary measure (although we all know how ‘temporary’ government levies tend to be) that applies a 0.1 percentage point increase on land tax for properties valued over $300,000. The idea is to recoup some of the debt the government racked up during the pandemic. In other words, landlords are being saddled with the bill for the State’s pandemic policies.
It is not hard to see why a left-wing Labor government might find such policies appealing. Land taxes, particularly when framed as progressive measures targeting ‘wealthy’ property owners, fit neatly into a redistributive agenda. By reducing the tax-free threshold and increasing rates for higher-value properties, the government can claim to be addressing inequality while generating much-needed revenue to fund its social agenda and infrastructure projects.
But hang on … isn’t land tax a ‘good tax’? Didn’t Milton Friedman support land taxes? It is true, in a 1978 interview, Friedman said “the least bad tax is the property tax on the unimproved value of land, the Henry George argument of many, many years ago”. Mind you, there is a huge difference between taxes being ‘good’ and being the ‘least bad’.
Economist, journalist, and social reformer Henry George (1839-1897) is best remembered for his advocacy of the so-called ‘single tax’. He argued that land, as a natural resource, was a key source of rising inequality because landowners could profit from its increasing value without contributing to its improvement. His ‘solution’ was a land-value tax, which would capture ‘unearned’ value generated by land that could then be put to public use. In theory this ‘single tax’ would replace all other taxes and reduce inequality in the economy.
Geo-rent is built upon bold assumptions.
Henry George remains well known, and his ideas are popular with policy elites in Australia. George visited Australia in 1890 and gave a series of lectures on his ideas. In 1891 the Australian Labor Party added a land tax on the unimproved value of land to their party platform. When elected in 1910, the Labor Party introduced a graduated (progressive) land tax, but did not abolish other taxes. The Menzies government abolished the federal land tax in 1952. While Labor did undertake to reintroduce a federal land tax in 1957, by 1974 the proposal seems to have disappeared off the radar. As we know, land taxes remain popular with Australian state governments. The idea of taxing ‘land’ has been around for a long time. Sir Moses Finley discusses land tax in the Roman Republic, and also indicates that the Greek city-states took the view that any form of direct tax on land ‘was a mark of a tyranny’. So, we have something of a puzzle. There appears to be a good argument for land taxes, they are popular with government, so why don’t we see more of them? Well, it turns out that land taxes are unpopular with the electorate and are ultimately based on faulty economic reasoning.
Our story on why land taxes are not a good tax has a very unlikely villain: Adam Smith. The founder of modern economic thought made a mistake in his 1776 magnum opus An inquiry into the nature and causes of the wealth of nations. Adam Smith discusses the application of land tax in England, dating back to 1692. Like all classical economists, Adam Smith made use of a ‘cost theory of value’ and concluded that land value arose from some sort of monopoly power. As the great economic historian Joseph Schumpeter states, Smith started “on its career an idea that was to find sponsors again and again and has not even yet died out”.
FALLACIOUS ECONOMICS
It is important to understand here what is meant by ‘land’. Land is an economic factor of production and is considered by many economists to be a bounty of nature. In this view all natural resources are defined as ‘land’. Economists define ‘rent’ as the return for the use of land. This may seem unexceptional; in this instance, however, we need to carefully define what is meant by ‘rent’. Rent is the return to land independent of any capital or labour that has been invested in it. Adam Smith refers to a ‘ground rent’, while the late Fred Foldvary (a research fellow at The Independent Institute) created the term ‘geo-rent’ in honour of Henry George.
The basis of geo-rent is built upon some very bold assumptions, but it is important to understand the basis of the claims being made. The principle underlying geo-rent is that land has value independent of any capital improvements. In particular, it has value independent of its current usage. That value—the geo-rent—is determined by the land’s most profitable usage, and the usage of adjacent land. It is possible to increase (or decrease) the geo-rent by improving adjacent land, but not by improving the land itself. In other words, externality forms an important part of geo-rent. Government, by providing public services to an area, or changing zoning laws, can increase geo-rents through externality. Consequently, it can be argued that taxing those rents is an equitable form of raising revenue. This type of geo-rent tax is also known as a ‘land value capture tax’. The idea is that public investment in infrastructure leads to windfall gains for some property owners. A land value capture tax recoups some of the public investment in public infrastructure.
Theoretical benefits quickly run into practical difficulty.
From a purely economic perspective geo-rent taxation potentially has an important attribute. Adam Smith had argued that the so-called incidence of the tax could not be shifted: the landlord pays the tax. A familiar argument against various forms of taxation is that the tax will simply be passed on to consumers. Adam Smith argued this could not happen in the case of land tax.
This means the tax is capitalised into the property’s value. The original landowner bears the entire tax burden and sells the property with the tax burden detached from the property. Future owners simply collect and pay money to the government, but this has no impact on their expected returns.
The view that land tax could not be shifted from the landlord remains popular. Public finance textbooks still give geo-rent tax as the example of a tax that cannot be shifted. The rationale for this view is that the supply of land is fixed and consequently ‘inelastic’. Standard economic analysis indicates that the owner of a taxed item with inelastic supply will pay the entire tax levied on that item. In short, a geo-rent tax should reduce the value of land by the extent of the tax. If this view is correct, a geo-rent tax is an efficient mechanism for government revenue. Some readers may recall this was the logic underpinning Kevin Rudd’s ill-fated 2010 mining tax. Even F.A. Hayek indicates, “If the factual assumptions on which it were based were correct … the argument for its adoption would be very strong”. But, of course, those assumptions are wrong.
Geographically, there is a finite amount of land in the world—but this is not the case economically. As the great American economist John Bates Clark argued, “The idea that land is fixed in amount … is really based on an error which one encounters in economic discussions with wearisome frequency”. Land (like all other economic resources) should not be defined in geographic terms, but in economically productive terms. Land, like capital, is mobile—it can be reallocated from one use to another. The notion that buyers of land face an inelastic supply curve in the short and long run alike assumes that geography is the sole determinant of supply.
In 1848, John Stuart Mill argued in favour of the geo-rent on the basis that the rent increases as economic activity increases, and so landowners were being taxed on unearned income:
The ordinary progress of a society which increases in wealth, is at all times tending to augment the incomes of landlords; to give them both a greater amount and a greater proportion of the wealth of the community, independently
of any trouble or outlay incurred by themselves. They grow richer, as it were in their sleep, without working, risking, or economizing. What claim have they, on the general principle of social justice, to this accession of riches? In what would they have been wronged if society had, from the beginning, reserved the right of taxing the spontaneous increase of rent, to the highest amount required by financial exigencies?
At face value, this seems to be a reasonable argument. It is related to the previous notion that geo-rent taxation has no deadweight loss associated with it. At the same time, it emphasises the notion that there is no entrepreneurial action associated with increases in geo-rent. As before, however, this argument would be powerful if the underlying assumption was correct. The underlying assumption here is that increases in societal wealth manifest themselves in increases in geo-rent.
As an empirical matter that implies that geo-rents (and land rents) should either remain as a constant percentage of national income, or even increase as national income increases. Gregory Clark, economic historian at the University of California, Davis, has shown that English land rents (which by definition include geo-rent) have fallen since 1760. Farmland rents have fallen from 23 per cent of national income to 0.2 per cent. Over that period urban land rents have increased in value, but still only constitute four per cent of national income. Clark argues this trend is the case in all modern high-income economies. The notion that landowners are the recipients of massive unearned increases in wealth that can be taxed with impunity simply does not accord with the empirical record.
So, we can find a theoretical argument for geo-rent taxation: it is certain, non-distortionary, and non-arbitrary. But there is almost no empirical evidence to support these claims, and the theoretical benefits quickly run into practical difficulty.
CALCULATING LAND TAX
The only criticism Smith had of the land tax was that it had an unequal impact on the population. This was due to a peculiarity of the British land tax: land values had been established in the distant past and not updated. As the economy grew and evolved, so distortions in land values led to the tax becoming unequal. Smith, however, did not favour frequent revaluations. He had three criticisms of revaluations; first the tax became less certain, second the administrative cost of the tax increased, and third Smith suggests that error in separating geo-rent from improvement value may occur. This latter objection becomes important for if any portion of the tax falls on improvement value, then the non-distortionary nature of the tax is undermined.
Geo-rent valuations by a bureaucrat lack entrepreneurial insight.
Smith was practical. While he indicates it should not be difficult to identify the geo-rent in theory, he also recognised there may be a practical difficulty that confounds the calculation. Mill took the opposite view. He argued “there would be no means of distinguishing in individual cases” between the geo-rent and the capital improvements in the value of land. British political economist and politician David Ricardo (1772-1823) indicated that following the imposition of a geo-rent tax, landlords would find ways of passing the tax on to their tenants or consumers. Clearly the classical economists thought geo-rent tax has desirable theoretical properties, but they were uncertain whether those properties could be practically implemented. Those theoretical debates have been bypassed by modern governments.
The Valuer-General in each State (and the ACT) values the ‘unimproved value’ of land—estimates the geo-rent. In fairness to these individuals, this is a difficult task and there is no suggestion that any of them is not doing the very best they can to derive a value. The process, however, is fatally flawed in at least two respects. First, the valuation process involves estimating the value of the land using comparative market prices. While that seems sensible, it overlooks the fact that the supply of land on the market at any time will have an elastic supply, while the theory of geo-rent requires the supply of land to be inelastic. In other words, it is not clear that the Valuer-General has estimated geo-rent with any degree of accuracy at all.
The second problem is that the Valuer-General is a bureaucrat estimating what he or she thinks the geo-rent would be on the open market, if the land were put to its best use. These valuations lack entrepreneurial insight. Unless the Valuer-General was risking their own money on their valuations, there is no reason to believe the valuation approximates a market value. If it were possible for bureaucrats to establish market prices there would be no need for markets. The entire argument in favour of geo-rent taxes rests on fragile assumptions. Once we recognise that land can have an elastic supply curve, the notion that geo-rent tax falls on monopolistic landowners may well be false.
DOES GEO-RENT EVEN EXIST?
An important issue, however, has been side-stepped. The argument so far has related to whether the geo-rent can be established with any level of accuracy, but that raises the question: does the geo-rent exist at all? Neither Frank Knight—famous as one of the founders of the free-market Chicago School—nor Murray Rothbard, disciple of Ludwig von Mises, thought the geo-rent existed. In 1933, Knight wrote, “The theory underlying this doctrine is one of the most rudimentary and obvious of all the fallacies ever promulgated in the name of economics”.
People should focus on there being no free lunches.
Knight’s argument against geo-rent taxation was simple; there is no evidence to suggest that land ownership generates any greater return than an investment in any other asset. In his 1921 classic Risk, Uncertainty, and Profit, Knight argued that the notion of land being in fixed supply was ‘utterly fallacious’:
It should be self-evident that when the discovery, appropriation, and development of new natural resources is an open, competitive game, there is unlikely to be any difference between the returns from resources put to this use and those put to any other.
Unless money grows on trees, nature does not simply provide economic assets. Even if money did grow on trees, it would require a labour input in order to pick the money off the trees. In a hunter-gatherer environment nature may well provide some bounty, but at any level of economic activity above hunter-gathering natural produce must be combined with capital, labour, and entrepreneurial insight before economic value can be established. Even hunting requires an investment in skills and human capital. When establishing the notion of ground rents (geo-rent), Adam Smith used the example of collecting kelp to create alkaline salt. The land or the kelp itself did not generate a return; the knowledge that alkaline salts can be derived from kelp and subsequently turned into soap generated the returns. The geo-rent is not inherent in the land; it is a return to entrepreneurial discovery. Land is an input into the wealth creation process, as is any other factor of production.
We are all poorer when taxes are increased.
This effectively was Rothbard’s argument, too. Landowners perform a valuable entrepreneurial function by bringing productive land into use. This is a service function which the classical economists, who had first promoted geo-rent taxation, tended to undervalue. Rothbard’s mentor, Ludwig von Mises has an amusing section in his Human Action where he discusses the ‘myth of the soil’.
A real peasant does not indulge in ecstatic babble about the soil and its mysterious powers. For him land is a factor of production, not an object of sentimental emotions. He covets more land because he desires to increase his income and to improve his standard of living.
Clearly von Mises had the view that the idea of land having some intrinsic value above and beyond what entrepreneurs could establish in usage was ‘ecstatic babble’.
NO FREE LUNCHES
Rather than quoting Friedman on land tax being a good idea, people should focus on there being no free lunches. F. A. Hayek had very qualified support for a land tax—if the assumptions were correct—but all too often too few people examine those assumptions in any detail.
People arguing for greater land taxes can point to Adam Smith (and modern statistical techniques) to support their position. But the fact is that all taxes have costs—sometimes quite high costs. A ‘free’ tax policy is very likely to have severe distortionary effects on the economy.
We saw this play out in 2010 when, using this very logic, the then Rudd government rolled out the Resource Super Profit Tax. The argument then was that miners had monopoly access to the bounty of nature that really belonged to the Australian people. That bounty, of course, belongs to the States and miners pay royalties to access those bounties—but logic was not the point of the exercise. We were told that taxing that bounty would have no impact on the economy or investment. The population very quickly saw through that argument.
The argument that increased land taxes are a tax on the wealthy and would have no impact on the economy is just a variation on a theme. We are all poorer when taxes are increased.
Human ingenuity creates value; not government, not bureaucrats. Value certainly is not a free gift of nature. All taxes ultimately fall upon humans and human ingenuity. It is profoundly dishonest to suggest anything different. Taxes will always be passed on to consumers in some way or another. Efforts by government to obscure this reality allows them to bamboozle the electorate into accepting poor public spending decisions on the basis that taxes will be paid by ‘the wealthy’ or, at least, someone else.
Increased taxation of land and housing is not just a burden on landlords, it is a burden on renters at a time when rental affordability is at crisis levels. It is not ‘greedy’ landlords who are to blame for this crisis, but poor government.
This article from the Summer 2024 edition of the IPA Review is written by IPA Adjunct Fellow Sinclair Davidson.
