Australia's Future Tax System

Final Report: Detailed Analysis

Chapter C: Land and resources taxes

C2. Land tax and conveyance stamp duty

C2–1 Land is (potentially) an efficient tax base

Taxes change the prices that consumers or businesses face. But a price change is not the source of the efficiency cost of a tax. The efficiency cost depends on whether people change their behaviour in response to the change in price. For example, the measure of the inefficiency of a labour tax is not how much it raises the wage cost to firms, but how many workers are not employed as a result. That is, the cost to society is the value of the activity deterred by the tax.

Land value tax is efficient because the tax reduces the price of land but does not affect how it is used, or how much is used.

Unlike capital and some labour, all land is immobile. If returns to capital or labour are higher elsewhere, those factors of production will tend to move toward those returns, but land cannot do so. This means that, in response to changes in demand, it is only the price of land that is affected, not how much it is used. The more (less) people are willing to pay to use the land, the higher (lower) the value of the land.

When a land value tax is introduced, the existing owners of land bear the burden of the tax as a reduction in land values. Potential buyers of land will reduce how much they are willing to pay for land by the value of the expected land value tax payments. That is, the value of land reflects the future after-tax earnings on land — with a tax in place, people will buy land only when they can pay less for it. Potential buyers will expect to get at least the same risk-adjusted return from land as they could from alternative investments. That is, land value tax reduces the value of the land to equalise the after-tax return to land with the return to other investments. This means that land tax does not distort investment decisions.

Someone must use the land, though; because it is immobile, it cannot be shifted out of supply. This makes land an efficient tax base. While lowering the price of land, a broad land value tax does not change how land is used. Since land value tax is paid by the owners of land regardless of what they do with it, the use of the land is not affected by the tax. The landowner cannot reduce their tax liability by changing land use — an empty block pays the same tax as an identical developed block since both blocks accrue the same 'economic rent' over time (see Chart C2–1 and a technical exposition at the Annex C2 to this Section).

Nor does land value tax change how other productive resources are combined with land. If a landowner were to try and 'pass forward' the tax to users of the land, some users (particularly highly mobile international investors) would simply reduce their use of land, lowering the demand and price for the land. When broadly applied across all uses of land, the introduction of a land value tax should not affect whether land is used for agriculture, housing or manufacturing. Even if a business (such as a farm) uses a disproportionate amount of land to produce goods and services, it will not be affected since the price of land is commensurately lower.

Land value tax therefore differs from taxes on other productive resources: taxes on labour reduce people's work effort; and taxes on capital can cause the capital to be employed elsewhere (particularly overseas). In contrast, a broad land value tax is borne by landowners and the supply of land is unchanged. Land value tax falls on the owner's 'economic rent' (see Box C2–1).

The relative efficiency of land value tax is supported empirically. A recent OECD report found that a 1 per cent switch to land or property tax (but not to taxes on transactions) away from income tax would improve long-run GDP per capita by 2.5 percentage points (Johansson et al. 2009). This study did not assess taxes on the economic rent from natural resources, which are also potentially efficient tax bases (see Section C1 Charging for non-renewable resources).

Box C2–1: Land value tax as a tax on economic rent

Because land is immobile, it is 'fixed in supply' (S in Chart C2–1).

The returns to the landowner tend to be made up of economic rent (area ORCB in Panel A). Changes in the price of land — that is, the annual rental return — do not change the supply of land. The demand for land (D) sets the rental return from the land (R) and the amount of economic rent accruing to the owner.

Economic rent is the return to the owner above that needed to keep the land in its current use. That is, it is the return once the owner has been compensated for the capital and labour they employ on the land. Economic rent therefore flows from the efforts of others, or simple luck. In particular, the economic rent of an owner's land increases as surrounding land increases in economic productivity (for example, from new roads built nearby), rather than the owner's investment in the productivity of their own land. Land rent is likely to increase in line with future population and economic growth, which increase demand for a fixed supply of land.

Chart C2–1: Effect of an annual land value tax

Panel A: Rents (cost of land) not affected

Chart C2–1: Effect of an annual land value tax - Panel A: Rents (cost of land) not affected

Panel B: Price of land falls

Chart C2–1: Effect of an annual land value tax - Panel B: Price of land falls

If an annual land value tax of t is introduced, based on the value of the land (which amounts to the same thing) then the total revenue is shown as OtAB in Chart C2–1 Panel A. Since supply is fixed, the same amount of land, B, is still available at the same rent (R) — the users of land are unaffected. However, the owner now has a lower after-tax rental return of Rt.

As the capital value of the land is equal to the discounted present value of all the future expected rental returns, a lower rental return implies a one-off fall in the value of all land. Owners of land bear the incidence of the land value tax even if they sell their land in response to the tax.

Panel B shows the impact on the price of land for sale (rather than its rental return). Since the buyer knows they will be subject to land tax, their demand falls commensurately (D(t)). As the supply of land is fixed, the present value impact of the tax is realised as a fall in price (from P to Pt). The effective rate of tax levied on owners is discussed in the Appendix.