Seizing the Opportunities for Social Reform

Dick Netzer

[A paper presented at the 13th annual conference of the Council
of Georgist Organizations, Los Angeles, California, 24 July, 1993]

Other speakers, notably Nick Tideman, have been and will be addressing what is surely the most exciting of opportunities, the reconstruction of economic and political institutions in the former Communist countries. I want to address a more conventional subject for you, reforming the system of local taxation in advanced industrial countries, especially those countries that have experience with -- and have not foolishlessly abandoned -- taxes related to the value of real property. I believe that there is a real opportunity -- a window, if you will -- for substantial reform that is here right now.

Beginning in the middle or late 1980s, there have been serious fiscal difficulties in most, if not all advanced industrial countries, in North America, Europe and even Japan. In at least some countries, the fiscal difficulties have led, or are encouraging, reduction in the extent of central government responsibility for the financing public services. This is quite marked in the U.S. by now: the Great society and the 1960s and 1970s have been repealed in an important sense-the shift to greater federal government responsibility that was a hallmark of that era. Putting aside social security and Medicare (not things that are easy to dismiss so readily, however), the federal government now finances a smaller percentage of civilian public expenditures than was true in 1965.

In some federal countries, there has been a parallel effort at the next level of government, with responsibility shifted from the state and provinces to local authorities. Californians have seen this dramatically recently; it has been happening in New York, most Northeastern and some Midwestern states for five years or more. In combination, these "downward" shifts in fiscal responsibility have reversed the very long-term trend shrinking the role of local governments, in this country, that reversal inevitably results in somewhat greater reliance on the property tax, or if not greater reliance, at least an abatement in the long-trend downward trend in the relative role of the property tax.

A Reversal for the Property Tax?

In fact, there seems to have been a small reversal in recent years in the U.S., as Figure 1 (for 12-month periods ending in June of the year indicated) shows. In 1970, the property tax provided just over 40 percent of state and local government tax revenue; by June 30, 1978, just after Proposition 13 had been adopted but on the eve of its effective date, the share had shrunk to 34 percent and, by 1980, to just over 30 percent, where it has hovered until recently, when the share began to increase.

There are a variety of factors, aside from the reality of fiscal retrenchment, that would seem to provide opportunities in the advanced countries for greater reliance on local taxes related to the value of real property. For example, in a number of countries there has been a rediscovery of the virtues of regional autonomy in public decision-making, like Spain and (to a much lesser extent until very recently) Italy. Initially, this has meant in practice that regional governmental machinery has been created and duties assigned to these entities and the scope of the responsibilities of existing local authorities has been expanded, but the finance has been entirely provided by the central government.[1] However, it is quickly seen that it can be a fatal error to rely wholly on central government financing, that the new regional authorities and the enhanced local authorities need financial instruments of their own, and that those financial instruments need not be clones of the taxes that the central government uses. Indeed, it is best-from the standpoint of establishing both the autonomy and identity of local and regional governments-that the local tax instruments be different ones. None of you will be surprised to learn that there are voices now saying that the appropriate local tax instrument is something we would call a property tax.

In a way, this is a revival of the doctrine of fiscal federalism that dominated the United States for about fifty years from roughly 1890 on, a concept known as "separation of sources," and one that I always have felt was abandoned prematurely. The doctrine says that, where there are multiple levels of government -- three, in a true federation-it makes sense, by and large, for each level to depend largely for its own-source revenue (with due allowance for inter-level fiscal transfers) on tax instruments that are unique to that level.

The doctrine was born when the federal government's main sources were customs duties and excises on distilled spirits, and both the state and local levels depended almost entirely on property taxes: thus the practical significance of the doctrine then was its encouragement to the states to abandon use of the property tax for state purposes, in favor of other tax instruments, initially motor fuel and motor vehicle taxes and, beginning in the 1930s, sales taxes. Many still subscribed to the doctrine as late as 1950, but then its died, to be succeeded by the prevailing current doctrine, which is that the states should tax retail sales and everything taxed by the federal government while local governments should tax property values and everything taxed by the state governments.

The prevailing doctrine today also supports an elaborate superstructure of intergovernmental fiscal transfers; together, the overlapping of tax sources and the intricate-or Byzantine- network of transfers has been celebrated, idiotically, as that wonderful thing, "marble-cake federalism" and a worthy successor to the primitive "layer-cake federalism" of the dead past. However, it is increasingly understood that the Byzantine network of transfers does not work all that well in practice, nor conform to any known theory of how government decisions should be made.

If "marble-cake federalism" works badly in the most advanced country where the rule of law and personal honesty are the norms, it works even more poorly in developing countries and other countries undergoing dramatic changes in the institutions of government. Increasingly, advisors to such countries are recognizing the necessity of stripped-down and simplified systems of intergovernmental transfers and a substantial degree of local revenue-raising based on something that looks like "separation of sources." And if there is to be separation of sources, at the local government level the obvious candidate is property taxation.

So, the case for taxing property values looks more encouraging than it has done for a long time. And, if taxes on property value are to be used more intensively in countries where they already are employed non-trivially, and if such taxes are to be adopted in places that have not been using them at all, then surely there must be real opportunities for land value taxation. I cannot remember a period in my adult lifetime when this has been true; instead, the case for land value taxation always has had to be made in an environment in which land value taxation was tarred by the brush that smeared the name of the property tax overall.

Getting Through the Window of Opportunity

I do not propose to tell you how meritorious land value taxation is, in this favorable climate. Instead, I want to revisit the old problem: how to gain adoption of land value taxation in this country, in a climate that seems propitious. This calls for consideration of this apparent paradox:

• You and I (as well as every economist who has thought about the question for even a few minutes) agree on the merits of land value taxation;
• But it is hard to get serious consideration in the real world, perhaps especially in countries that are used to the idea of taxes on the value of real property.

Why is this? Clearly, there is ignorance and anxiety among both ordinary people and politicians about what land value taxation is and means and will do. However, I think we need a different starting point: the fact is that contemporary and uniform valuation of taxable property, which is an essential ingredient of land value taxation, is hated and feared almost everywhere. It is important to think about the sources of that hostility, and the closely-related hostility to land value taxation, so that we can think usefully about the kind of legislation that should be proposed, with an eye to acceptance, not hysterical rejection. To put the issue another way, suppose that elected officials have been gradually won over. What is the shape of land value taxation least likely to produce a fire-storm of opposition and to be thrown out in short order, especially in places with initiative and referendum provisions, but elsewhere as well?

I have agonized over the question of why voters are so hostile to up-to-date and uniform valuation of property for tax purposes. Some of the explanation has to be that the anxiety that can be traced to a simple illusion, the notion that if my property is re-valued from 10 to 100 percent of market value, my taxes also will rise tenfold, even if all other property is similarly (or even more) re-valued. I have argued elsewhere that most ordinary people do not consider the taxation of unrealized capital gains, which will occur with continuously updating of taxable property values to reflect changes in market value, to be legitimate; most Americans consider taxation of capital gains appropriate only when gains are realized. Like other economists, this notion is alien to me -- but we are only about .03 percent of the voting population.

Let me present you with some estimates that will reinforce your convictions about the merits of land value taxation, but which simultaneously should suggest the magnitude of what it is that worries many ordinary people about any system of property taxation that begins-as land value taxation must begin-with up-to-date valuation of whatever it is that will be taxed.

A large fraction of the increase in the market value of owner-occupied housing over time consists of increases in the market value of the land underlying that housing. In fact, one can ascribe all of the increase in market value of such properties in excess of the increase in the depreciated replacement cost of the structure to land value increases.

The median price of a new privately-built single-family house in the U.S. rose from $23,400 in 1970 to $122,900, an increase of 425 percent. Meanwhile, the depreciated replacement cost of owner-occupied residential structures rose from a mean value of $14,400 to a mean value of $60,315, an increase of 319 percent.[2] The latter rise reflects inflation in building costs over the period and improvements in the quality of houses. The large difference between the two sets of data must be explained by land value increases.

At the risk of overly complicating the argument, I want to translate this into some fairly stark numbers. This requires some heroic estimates, in large part because federal statistical agencies rarely provide explicit data on the market value of types of nonfinancial assets. Using various bits and pieces of data, I come up with an estimate that the market value of the land underlying single-family owner-occupied houses in the U.S. increased by about $555 billion between 1971 and 1990. The first half of this period was highly inflationary in general, but the average annual increase in these land values between 1971 and 1982 -- 15.1 percent-was far in excess of the rate of inflation.

Even in the non-inflationary period since 1982, land values have continued to increase, and more rapidly than the price level.[3]

From the standpoint of the land value taxation advocate, we have -- using 1971 as the starting point-more than one-half trillion dollars that can be recovered for public purposes, $0.5 trillion that owes nothing to the efforts of the individuals and households that own those assets. From the standpoint of ordinary homeowners, there is a 560 percent increase (assuming they owned the property 19 years earlier -- the compound annual rate of increase is 10.4 percent) in the base for tax liability that might confront the homeowner with land value taxation, or with any other property tax reform that is connected with current, accurate and uniform valuations.

That has to be a frightening prospect, or at least a prospect that can be made to seem frightening by the demagogues who seem so easily uncovered in controversies surrounding property taxation in the U.S.

Distinguishing Owner-Occupied Residential Property

It is implausible that ordinary people can be stampeded with horror stories about the impact of up-to-date valuation as a basis for taxation on owners of business property or of land that is not under one's own house. It is the possible impact on owner-occupied residential property that provides the fears and the votes.[4] Let us now consider land value taxation explicitly, not just up-to-date valuation for the ordinary property tax, and how owner-occupied housing might be treated under land value taxation. It is true that, in the typical American city (one that does not have a formal classification scheme that provides explicitly for much lower taxes on homeowner residential property than on other types), adoption of full-scale land value taxation would leave the owner-occupied housing share of the total tax levy unchanged or even slightly lower than is the case with the present system. But-your typical voter will respond -- "so what? What about MY house?"

I suggest that practical proposals for the initiation of land value taxation include substantial insulation for land under owner-occupied houses. To simplify, assume that what is being considered is complete untaxing of improvements, in a community that contains a variety of land uses. (In other words, it is not a dormitory suburb with nothing but owner-occupied houses, nor a completely agricultural community; in either of those two extreme cases, land value taxation should have next to zero effect on the distribution of property tax liabilities among individual taxpayers.) What we want is a device that, at the outset, provides some reduction in the share of the total tax bill borne by owner-occupants, and some continuing insulation from the full effect of land value increases, with minimal bonanzas for the richest of owner-occupants.

A homestead exemption that is a percentage of the value of the median value lot under owner-occupied housing fits that set of specifications. (For the sake of simplicity of exposition, I speak of an exemption that applies only to owner-occupants, but I mean one that can include housing that is rented.) Take a homestead exemption equal to one-fourth of the value of the median lot; with the usual relationship between median and mean property values, such an exemption might reduce total taxes paid by owner-occupants by 22 percent. Now suppose that owner-occupied housing accounted for 65 percent of the value of all taxable property before the adoption of land value taxation, but that it accounts for only 60 percent of the value of land. With the homestead exemption, owner-occupied property will account for only about 54 percent of the value of all taxable property.

So, at adoption, owner-occupants as a group will enjoy a relative shift in the tax burden (roughly a one-sixth reduction), and that advantage will not be dissipated over time (as is the case for fixed-dollar homestead exemptions). Equally important, the advantage will be greatest for those with the properties whose land value is quite modest. It has the sound of a vote-winner.

But is throwing away the economic efficiency advantages of land value taxation? I think not. My proposal would be inefficient, if it blocked economically appropriate changes in land use. The neutrality of land value taxation does not depend on how uniform the tax is, but on the independence of the amount of tax paid from the nature and extent of the improvements actually on the land. If, because of zoning and building codes or other variables that have nothing to do with the tax regime, there are no practicable alternative uses of the site except for the kind of housing that it is now used for, which is a very common situation, the exemption will not affect land use. If the exemption is offered only for those properties that qualify at the time of adoption, but then continued regardless of use changes, it will not affect land use, but only the distribution of land rent.

The proposal of course requires refinement, in the interests of legality, application and economic efficiency. My economist friends can suggest any number of wrinkles, as well as alternative ways to insulate ordinary housing occupants from tax. But I believe that some form of insulation is essential.

Conclusion

As good an idea as land value taxation was a century ago, in some important ways it is even better today, because the advanced countries have tried so many other tax regimes, with unhappy results. But what we need is to get real movement in practice, with success stories that can be emulated. Hence my pitch for disarming the opposition by the use of an admittedly impure form of land value taxation, but one that I think has reasonable political prospects.

NOTES AND REFERENCES

1. Americans will find it instructive that Italian, Spanish and French journalists and analysts, as well as bureaucrats, tend to refer to these entities as "the regions;" it seems that the regions (except perhaps for some in Spain) are not yet real places in which people live and work, but mere governmental machinery.
2. These data have been calculated from the U.S. Department of Commerce, Bureau of Economic Analysis series on "fixed reproducible tangible wealth," a data set that uses the depreciated replacement cost approach to valuation for all the assets it covers.
3. It has been argued that there is a persistent upward bias in the consumer Price index, largely related to the egregious failure to reflect quality improvements adequately, which is worse in years of relative price stability. That would suggest that the price level really has increased little since 1982, while land values have continued to rise.
4. This might have been said about farmland some years ago, but now there is preferential assessment for farmland everywhere. That preferential treatment should protect farmland owners from increases in assessments that reflect increasing demand for land for non-agricultural uses.