Incentive Property Taxation:
A Potential Tool for Urban Growth Management

Thomas A. Gihring

[An abridgement, from APA Journal, Winter 1999]

The urban land use planning profession, having received its legal basis historically from stare enabling legislation and the local police power, has grown comfortable with the regulatory environment as a modus operandi. Rarely have planners looked beyond regulations for solutions to the twin problems of urban sprawl and central city stagnation. This study opens the case for a revised property tax system, by examining its power to influence land use allocation and its potential as a supplemental tool for managing urban development.

Recently, two vocal environmentalists have raised the issue of property taxes and their effects on the contemporary urban landscape. Both denounce the present system of property taxation as regressive. In his book Home From Nowhere (1996), James Kunstler targets the car-dominated American habitat as a failed experiment, asserting that "our system of property taxes may be the single most insidious, pathogenic factor contributing to the geography of nowhere" (Kunstler 1996). Alan Durning of Northwest Environmental Watch makes the argument This Place on Earth that the nation's existing tax codes send the wrong message by penalizing work and investment, thereby accelerating urban decline (Durning 1996).

Adhering to a progressive liberal view of economic justice, proponents of the "green tax" movement maintain that value should accrue to the creator of value (Katzenberger 1992). The three factors of production commonly cited as combining to produce wealth are labor, capital, and land, where:

wages are the return to labor, interest is the return to capital, and rent is the return to land, or to the steward of land, which is the public domain.

Unlike capital and labor, which are associated with productive enterprise land refers to the gifts of nature. The mispricing or misuse of these free, fragile natural endowments, limited in quantity, leads to environmental degradation. According to Durning, "Taxes on [land] raise the price of using [it], which tells people to conserve. … Taxes on labor and capital tell businesses and households to scrimp on workers and tools -- ... to practice unemployment and underinvestment. A reasonable tax policy would tax the gifts of nature first and tax labor and capital only as a last resort" (Durning 1996, 227).

The alternative method proposed by Kunstler, Durning, and a growing number of environmentalists and converts to neotraditional planning rests on a foundation laid by a nineteenth century reformer. In his seminal book Progress and Poverty, the political economist Henry George laid out his fundamental premise for reform: the abolition of involuntary poverty by opening the earth's resources on equal terms to all. Wider access to land could be accomplished, he argued, by reducing taxes on wages and capital and raising taxes on land holdings. That would induce owners of unused sites to sell them at reasonable prices, thus bringing idle land into productive use and creating more employment (George 1880).

The basic principle recognized by land value taxation is this: land value accrues cumulatively, in a process generated by the community as a whole; as such, that value belongs to the community; it is only the building value that is created by private capital investment, and as such, belongs to the owner. Hence it is just for the public sector to appropriate land rent through taxation.

In its pure form -- the abolition of all taxes save the tax on land -- Henry George's theory was never actually applied. The idea of differential taxation, however, lived on and was incorporated into law in several British Commonwealth countries, Taiwan, Denmark, Holland, and two states in the United States. The city of Pittsburgh adopted land value taxation (LVT) during the municipal reform period of the 1920s, and several jurisdictions followed suit under Pennsylvania enabling legislation (Pickard 1962). In 1993, New York State adopted legislation allowing local use of the two-rate system. The stated aim was to stimulate development by increasing tax rates on land and reducing rates on buildings (Hennessy 1993).

Elements of Land Value

In contrast to the conventional, equal-rate system that applies the same tax rate to land and to improvements, a revised two-rate property tax structure taxes the assessed land value of each parcel at a higher rate than that on the building assessment. The two-rate system's rationale is exemplified particularly clearly in urban areas where land value is largely site value, that is, the market value generated by the presence of public infrastructure, nearby public and commercial facilities, natural amenities, and accessibility (Mills 1969). Thus, in principle, this heavier tax on land taxes mainly the land rent (or economic rent) created over time by the community at large, not the capital invested in the property improvements.

A second point here is the effect of the taxation system on owners decisions about improving property. In practical terms, for individual owners the market value of land is the speculative value of the given sites. We have noted that as land values rise, the increases can be preempted by owners through higher resale prices, or they can be captured (at least in part) by the public sector in the form of tax revenue. If an owner undertakes no capital improvements on a property, the future resale profit from that landholding is a purely speculative gain, or windfall; if the owner does add improvements, they also add to the amenity of the area, and thus create an increment of community wealth. But under the present equal-rate system of taxation, the owner has no tax-based incentive to invest in property improvements, because doing so will result in higher taxes. Thus, inherent in the equal-rate method of property taxation is a built-in disincentive to invest in substantial capital improvements.

Benefits of Land Value Taxation

Land use decisions by individual property owners could be affected by taxation if the financial incentives or disincentives were sufficiently strong in proportion to the full economic rent. That is, if the additional tax burden imposed on land by converting from an equal-rate tax to a land-based tax were to approach the speculative gain derived from land value inflation, an owner may decide to convert to a more building-intensive use or to sell the land to a buyer willing to undertake a substantial capital investment. Proponents of two-rate incentive taxation anticipate several significant benefits to the public interest (Gaffney 1993). They are elaborated below.

1. Placing proportionately higher taxes on land would make it more costly to hold on to vacant or underutilized, centrally located sites. Trends toward infill development and a gradual recentralization of urban development would emerge. The demand for peripheral sites at the urban fringe would correspondingly diminish.

2. Reducing the tax burden on improvements would facilitate revitalization and the replacement of obsolete buildings in older central cities. Property owners, responding to the financial inducement to reduce the land-to-building value ratio, would build more intensively on vacant and underutilized sites. The cumulative effect over time and space would be to increase property values, and thus the tax base, where that is most needed.

3. The two-rate tax would discourage land speculation, that is, the holding of unimproved or under-improved property for the purpose of reselling profitably without any substantial capital investment. A differential tax rate that was high compared to land price inflation could diminish the accumulating windfall for the holdout owner. That is, if the tax would capture a large portion of the land's economic rent, the owner would in all likelihood capitalize the depletion into a lower resale price.

Urban Growth Management

The previous discussion makes apparent the close relationship between the expected benefits of land value taxation and the commonly stated objectives of urban growth management (UGM). In general, UGM seeks to promote a suitable relationship between land use and infrastructure, that is, more efficient use of land in order to conserve land rather than consume it (Gallion & Eisner 1980). Land use efficiency can be achieved through compact urban form, establishing ordered relationships among the places devoted to utilitarian functions such as work, shopping, recreation, and socializing, and at the same time maximizing their compatibility (by defining zoning districts), maximizing accessibility (by designing a balanced transportation system and reducing distances between origins and destinations), and minimizing energy consumption.

Although the rationale for land value taxation is independent of UGM, the overlap of purpose is clearly discernible. In essence, the double-sided coin of incentive property taxation has these two principal objectives (Rybeck 1992):

1. Tax away the speculative value of property, by rewarding capital investment.

2. Bring idle land into production, by penalizing speculative land holding.

A two-rate system's expected outcomes can be summarized as follows:

· Discourage urban sprawl · Encourage infill development · Discourage building disinvestment · Intensify land development · Discourage land speculation · Restrain rising residential land prices

The overlap between incentive property taxation and UGM can be seen in the legislation adopted by the state of Washington in 1990. Emulating a model established by several precedent-setting states such as Oregon, California, and Florida, the Washington State legislature in 1990 adopted the landmark Growth Management Act (GMA), a comprehensive set of goals, strategies, and enforcement provisions to guide land development (Washington State Growth Strategies Commission 1990). The state's growth management objectives can be summarized as follows:

· Preserve rural open space and resource lands · Prevent sprawling, low-density development · Direct new growth to existing centers · Encourage infill and contiguous development · Encourage redevelopment in economically depressed sub-areas · Revitalize dedining central business districts · Use public infrastructure more efficiently · Reduce automobile dependency; support transit and pedestrian modes

Applying Incentive Taxation

To date, only limited attempts have been made to use the public's power of taxation to achieve growth management objectives. Both Washington and Oregon have adopted the practice of assessing farmlands, open space, and forestlands at current use value rather than full market value (that is, exchange value). The intent is to encourage farmers and foresters, through lower taxes, to continue natural resource-based economic activity and to resist the temptation to sell lands located in the urban fringe for development (Washington State Dept. of Revenue 1993).

Negative applications of incentive property taxation also are legally available but, again, in only limited use. The state of Vermont uses a Land Gains Tax to protect rural land from short-term speculation. A high capital gains tax on resale within a one-or two-year period targets owners whose intent in buying up resource lands was to profit from their conversion to urban use, and allows local jurisdictions to capture up to 80% of such windfall profits (Daniels, Daniels, and Lapping 1986).

Even less used are tax mechanisms that incorporate both rewards and restraints concurrently. Planners and lawmakers could profit by examining more carefully how incentive taxation could be used to simultaneously encourage wise land use practices and discourage land speculation and sprawling development.

The Two-Rate Taxation Method

Under the conventional, equal-rate property tax system, each owner's tax bill is prepared by multiplying the total assessed value (TV) by the levy rate, usually expressed as a per-thousand-dollar figure, or mill rate. For example, if the assessed value of a given property were $100,000, and the levy rate were $13 per thousand of assessed value, the tax bill would be $1,300. In each county the assessor calculates the levy rate by dividing the total projected revenues authorized for the various taxing districts by' the total assessed value of real estate in the county. To find the mill rate, the resulting ratio is multiplied by' 1,000.

Under the alternative two-rate property' tax system, the total levy rate is split, and applied differentially to land values (LVs) and to improvement values (IVs). The assessed land value of each property is multiplied by' the higher fraction of the levy rate, and the assessed building value is multiplied by the lower fraction. In this study, the proportionate rates for land and buildings are derived from a land value tax (LVT) level denoting the percentage of the levy rate that the taxing authority chooses to apply to the land value. …

Note that, in practice, the concept of revenue neutrality applies not to single parcels but to an entire taxing jurisdiction. Thus, individual properties' tax bills may be either higher or lower as compared to the conventional tax, though all are taxed under the same set of differential rates.

There is general agreement among the advocates of land value taxation that a two-rate system should be introduced gradually so as to minimize the effects of any abrupt change in tax billing for the owners most affected by the differential tax. A phase-in period gives the property owners whose taxes rise an opportunity to gradually adjust property prices downwards, as the capitalized market value of their land diminishes because of the land value tax (Congressional Research Service 1971). The phase-in also gives owners time to adjust their investment decisions. For example, the anticipation of increasingly higher land tax burdens may prompt the earlier sale of underutilized property, or investment in building improvements. A transition period -- maybe ten years, more or less -- during which the levy rate differential gradually' would rise to a concluding level, perhaps short of a 100 percent land value tax, would avoid undue financial stress on land owners. …

What is an appropriate concluding LVT level is subject to a variety of opinions. One would hope the rate differential would be enough to appropriate a substantial portion of the land rent within a taxing jurisdiction. In urban areas where growth pressures are strong, high land value inflation would be expected. Consequently, higher LVT levels might be needed in those areas to recapture the annual gains in land value. Where the real estate market is soft, however, too high an LVT level could trigger a shock wave that depresses property values excessively. In terms of the public interest, one could also aim for incentive effects that generate property upgrading and infill development activity.

There is no logical reason not to consider a full tax on land values (excluding an improvements tax). However, the choice was made in this study to advance a method which has some precedent in the United States, namely the Pennsylvania "two-tier" system. In any case, the amount of land rent captured by a full LVT would differ only minimally from that recovered by the 95% LVT utilized in this study.

Regulatory Issues

The following issues are raised briefly here with the aim of increasing the effectiveness of urban growth management in concert with land value taxation:

Concentric Holding Zones. Perhaps the most urgently needed requirement in the tool box of urban growth management is a mechanism to ensure contiguous, phased development emanating from established growth centers. Such a mechanism would define concentric holding zones beyond which new urban development activities (subdividing, construction, use conversion) would be restricted until a predetermined threshold ratio of developed area to total area had been exceeded. Upheld by the state's courts, a "tiered" growth control system is in effect in several New York State cities (Freilich 1992).

Large Lot Zoning. Cark County, for example, might consider abandoning large lot zoning designations, now regarded as temporary holding districts. Once the inefficient pattern of developing separate lots along county roads becomes established, the possibility of later replatting these sites within a planned urban street network is largely lost. Furthermore, land assessment practice should seriously consider the incorporation of lot sizes into comparable sales data. As a case in point, King County has adopted the assessment method of normalizing lot values on a square-footage basis. Under an LVT system, oversize residential lots would be subject to higher taxes commensurate with their potential return from land price inflation and their more extensive land use.

Land Banking. Land banking refers to the acquisition of land in advance of its intended development. The rationale for government purchase and holding of vacant parcels becomes more apparent when seen in the context of land value taxation. In some areas the market demand for permitted uses may not be maturing at the same pace that increases in the tax burden take effect. To avoid triggering premature development and forcing vacant land into low-intensity, undesirable uses through incentive taxation, a local public trust created for this purpose could offer a sale option to landowners.

Major Facility Siting Provisions. Washington State in recent years has aggressively pursued economic development strategies that offer generous sales tax abatements to major employers, with no siting stipulations. Such extenuation is fraught with danger to wise land use practices, in that the impulse to minimize land purchase costs can lead to leapfrog patterns of development. The external costs of sprawl, including infrastructure expansion and commuting travel costs, constitute an enormous burden on employees and taxpayers (Tillett 1995). It would be desirable for comprehensive plans under GMA guidelines to contain a major facility siting provision, obliging firms receiving tax abatements to locate within planned urban centers, with priority given to existing centers.

Conclusion

Land value taxation appears to offer much better prospects for promoting efficient land use, dampening land price inflation, and discouraging land speculation than does the conventional property tax system. In the case of the rapidly growing Vancouver UGA, its potential for short-term results is currently limited by high increases in land values. Its potential for long-term results depends on both the effectiveness of regulatory devices to direct the location of new urban growth, and assessment practices that incorporate the unit value of sites.

In the state ofWashington, a constitutional amendment would be required to allow counties the option of implementing differential rate taxation. The "uniformity clause" (Article 7, Section 1) provides that all taxes be uniform upon the same class of property, meaning that the land and improvements constituting all real estate must be taxed at the same rate. Despite this encumbrance, a coalition of Georgists and environmentalists continues to advance the proposition. The Association of Washington Cities adopted a resolution urging the state legislature to look into a two-rate system as a means to promote central city revitalization and to help cities meet requirements under the Growth Management Act (Heller 1993).

Land value taxation as a growth management tool is not a cure-all. Further study of its consequences should address questions about its applicability to more distressed urban regions, and include dynamic effects on property values and investment decisions. Perhaps the initial step in a new approach to urban growth management is to embrace a more progressive system of property taxation. Doing this means, first, recognizing the distinction between what is privately generated value in real estate, and what in principle belongs to the community.