Tax talk-fests and the importance of being dismal

Why is tax reform so hard? Reviews such as the Henry Review often point to ‘low-hanging fruit’ where efficiency gains can be made without any significant equity costs. One oft-noted example is property stamp duty, where the Henry Review recommended its replacement by land taxes. Taxes such as stamp duties, it is argued, discourage residential mobility and the most efficient use of the housing stock.

In general, tax theory tells us that the most efficient way to raise a given amount of revenue is to use a tax which does not distort behaviour. Taxes on transactions such as stamp duty and insurance taxes are rated as particularly distortionary because people can easily change their behaviour to avoid them. Taxes that are hard to avoid (eg land taxes) are much more efficient. Putting this another way, the change in behaviour as people respond to distortionary taxes means that the tax rates must be higher than otherwise in order to compensate for this inefficiency. Okuns ‘leaky bucket’ has to return more often to the well, the larger are the leaks in the bucket.

But if there is such consensus about tax efficiency, why has there been a distinct lack of political enthusiasm for replacing transaction taxes such as stamp duties with alternatives such as land tax (or even more ‘radical’ proposals such as death duties)?

An explanation that is often advanced against taxes on assets, is that someone with large assets might not have the cash flow needed to pay tax. On the other hand, when a large transaction is taking place, it’s easier for the tax office to cream off its take.  While this may have been a valid issue in the past – it is hard to see it as a serious constraint now. As the HECS scheme shows, there are ways of delaying liabilities until people have the required cash flow. In the case of a tax on assets, this could be delayed until the asset is liquidated.

A more fundamental problem, I suggest, is that efficient taxes are politically unpopular precisely because they are efficient. That is, people don’t like taxes on assets where they cannot easily change their behaviour to avoid them. Now, from the perspective of utilitarian welfare economics, this doesn’t make sense. The more behavioural change associated with a tax, then the higher must be the tax rate (to raise a given revenue) and so the average person is made worse off.

But the average person is irrationally optimistic. We have unrealistic views of how easily we might be able to avoid transaction taxes. To take property stamp duty as an example, people can push stamp duty taxes on hypothetical future home purchases (for themselves or their children) out of their mind – but an equivalent land tax is something that they would have to face immediately.

Can this political challenge be solved? I don’t know, but think that continued debate and discussion of tax reform (as exemplified by the recent tax forum) can only be a good start. Practitioners of the ‘dismal science’ need to work harder at spreading realistic pessimism.

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21 Responses to Tax talk-fests and the importance of being dismal

  1. Low expectations certainly make structural reform easier. E.g. This week Queensland just introduces a waste levy, roughly in line with other states, but much lower, taxing a negative externality. Securing reform (just before a state election is due!) was made possible by being dismal about states waste generation, and starting at a modest (dismal) levy rate. Only after everyone felt dismal enough was the space created for structural reform,i.e “dismality” was a necessary but not sufficient condition.

  2. Don Arthur says:

    I suspect part of the opposition to land tax is the role housing plays in retirement.

    Part of the reason people invest in housing is to provide security in retirement. People want to reduce their spending in retirement and avoid the cost and disruption of unplanned moves.

    Not only to land taxes increase the cost of housing in retirement (where many people’s financial plans depend on the cost being close to zero) but may rise to an extent where they are forced to sell the house and move.

  3. desipis says:

    That is, people don’t like taxes on assets where they cannot easily change their behaviour to avoid them.

    I wonder how much of that is related to the fact that people are more concerned about getting a good deal than they are about whether the purchase represents good value for them in the first place.

    I also suspect that any land tax would have a dampening effect on realestate prices by chasing off speculative investment, possibly to the extent of causing a realestate crash. So while it may make sense in the long term, the short term pain could make it politically difficult to implement.

  4. Russell says:

    What Don Arthur said.

    Also cynicism – surely any new tax will mean more tax.

    Plus, most of us have friends or siblings who are wealthy and increasingly so, but thanks to expensive advice, and loopholes, pay no tax, and won’t be paying any. Something like land tax will be unavoidable for ‘ordinary’ people, and have the depressing certainty of coming around every year, whereas stamp duty is something you don’t ever think about, unless you’re planning a move.

    One of the problems with asset taxes is the idea that once you’ve paid tax on your income you should be able to buy what you like without being taxed again – it seems like too much taxing! Maybe it would be better to just fix up income tax – a progressive system with no loopholes.

  5. Don: I think these types of issues could be dealt with by allowing people to delay accumulated tax liabilities until they sell (or possibly even until they die). Would this be enough to make such a tax politically feasible?

    Desipis: I doubt a land tax would have that much impact on house prices. It would have to be phased in and would replace stamp duties.

    Russell: I argued that people were too optimistic – you are doing a good job of proving me wrong! However, I would argue that land tax would be unavoidable for even the ‘unordinary’ people.

    Your point about negative attitudes to taxes that are paid frequently makes sense. Can this also be avoided by allowing delays?

  6. Russell says:

    No. I’m one of those people who pays a bill the day I get it, I don’t have any debts and I hate the idea of debt (OK, unusual these days). My parents, as pensioners, would rather have starved and paid that tax, than have their only asset they could hand on to their kids run down by accumulating debt. So, let’s have land taxes on all land except the family home.

  7. JMB says:

    I can see a parallel here with repayment of education costs. If the landowner (superannuee? Pensioner?) is on a small income, then the land tax debt may be deferred, for a small price. Once the income increases beyond a threashhold level, repayment is mandated.

    Death, of course, brings closure, if not foreclosure.

    I type this as a retiree on a limited income and with a relatively generous landholding which a mob or two of kangaroos and I enjoy. Council rates total about $40 per week, including water supply and garbage disposal. I guess that I am arguing against my own interests, however I would not move in a hurry if I was required to pay a land tax.

  8. Pedro says:

    Bruce, accumulated land tax is surely the same as stamp duty. A PAYG land tax on homes would have an effect on house prices by raising the cost of owning a home and an accumulated land tax bill is a disincentive to move.

    One of the problems with a land tax is that the impact of the tax lags economic changes and so will peak after a property cycle turns and thus bite hardest when some businesses can least afford it. It is a tax on capital and I thought there was plenty of work showing that taxing capital reduces capital formation.

  9. JMB says:

    Pedro, I imagine that an equal weight of literature is out there supporting taxing of capital. Kind of (in Rugby Union parlance) “use it or lose it”.

    Economists out there… can anyone shine a light on this?

  10. Don Arthur says:

    Bruce – You’re right, you dealt with the problem of taxing people with low incomes in your post when you suggested the tax “could be delayed until the asset is liquidated.”

    Pedro’s point about an accumulated land tax bill being a disincentive to move in just the same way as a stamp duty is a disincentive is interesting.

    If one of the objectives of a land tax was to encourage older people in large family homes to move, then allowing low income earners to defer payment would reduce the attractiveness of the tax.

  11. Pedro & Don: Accumulated land tax is different from stamp duty in that it increases the longer you hold the property. So it does not provide a disincentive to move. (Another way of thinking of this: Consider a person owning land of value X over some period. If they stay put, their land tax will be some proportion of X times the length of the period. If they move to another location, but with the same land value X, their tax bill will be unchanged. On the other hand, with stamp duty, the more they move the higher their tax). Allowing people to delay payment might change this a bit (depending on the interest rate changed on accumulating balances) but compared to stamp duty, land tax will still have much less of a relocation disincentive.

    ‘taxing capital reduces capital formation’. Land is not capital in this sense, because it does not get made – it is in fixed supply. This is not entirely true, as land use patterns can change over time, but is close enough. The Henry Review echos standard economic consensus when it lists land taxes as among the most efficient taxes.

  12. Don Arthur says:

    Bruce – Yes, it’s obvious that “compared to stamp duty, land tax will still have much less of a relocation disincentive.”

    The major exception to this would be groups such as pensioners who have deferred payment for long periods of time.

  13. Don Arthur says:

    Bruce – At #5 were you suggesting that some people would be able to roll over their tax liability if they sold their house and put the proceeds into another property (eg a unit in a retirement village)?

  14. Pedro says:

    That was my question, the accumulation only works if you can roll it over. Which I guess means the accumulation continues until you die or sell without buying, maybe because you’ve moved to a nursing home. Good luck promoting a death or permanent incapacity tax Bruce!

    On the question of capital formation. The value of land is most dependent on its use and improvement. I’m not arguing land tax is not relatively efficient, only that the times it really bites gives you little patches of potentially high inefficiency. You also have to beg the question of how the tax is calculated. There was quite a ruckus here in Qld when the govt tried to move to taxing what were effectively improved values.

    Don encouraging highest and best use of land was a long standing policy of the common law, with restrictions on entailing and such. But these days each pensioner taxed out of their home will be on the tele at 6.30 in tears and showing the photos of their kids in the back yard 30 years earlier.

  15. I’m not sure about rolling over. I think the incentives it provides will depend on the interest rate on the outstanding land tax. Either way, it might end up amounting to an estate tax. (Which is why people won’t be ‘taxed out of their homes’).

    Estate taxes, however, are apparently unpopular – which brings me back to the main point of my post. Why are these sorts of taxes unpopular? I suggest it is precisely because they are unavoidable. I think we need to work to educate people that they are being irrational when they they think that they can avoid the alternative taxes (such as stamp duty in this case).

    Re land tax: Yes it should be on unimproved value as Pedro implies. And yes, I think it should be applied to owner-occupied housing. Though in order to raise the same amount as stamp duty, the rate will be low (probably lower than local goverment rates, I’m guessing, though I haven’t done the sums). Finally, as Henry notes, some form of transitional arrangement would be needed to compensate people who’ve just paid stamp duty.

  16. Pedro says:

    I think all taxes are unpopular with the majority of the people who pay them. If estate taxes are especially unpopular it is probably because people don’t like the idea of their final gift to their children being snatched by the fiscal fiends.

  17. john says:

    In areas where sales of unimproved land are rare, ‘official values’ can get out of step with market reality,one unusual sale can skew valuations for a whole town. For example the official ‘value’ of my block has more than tripled in 7 years ,but realistic market prices are much the same as they were 7 years ago.

  18. john says:

    Some how the end of post 17 dropped off

    How would you fairly calculate the value of the unimproved land in situations were it is not possible to get much of actual sale prices and/or were the sale of artificial tax effective subdivision ‘investment’ schemes have ramped up prices ?

  19. Russell says:

    “I think we need to work to educate people that they are being irrational when they they think that they can avoid the alternative taxes (such as stamp duty in this case).”

    Quite likely not true for the elderly. My parents stayed in their home – they didn’t pay stamp duty, but they would have tried to pay your tax out of their pension. You have to think about people’s circumstances at times in their lives, not just some grand lifetime total of tax.

    “it should be applied to owner-occupied housing”. Are you trying to gouge more tax out of ordinary people? According to the Australia Institute there’s loads of tax money to be easily obtained by reversing some of Howard’s arrangements, eg superannuation. Why not start there, with the wealthy? Who cares about some dubious concept of ‘efficiency’ if the tax is inequitable? The rich won’t be paying your land tax – their accomodation will be owned by a trust, which is owned by … which will count it as a tax deduction, which will etc etc

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