Zero-Tax Party

Asset owners, when objecting to taxes on their assets, like to argue that investment in assets is a means whereby retirees can finance their retirements without burdening the taxpayers. But in that case, should not governments also own assets (or shares thereof), so that governments can finance their activities without burdening the taxpayers? If self-sufficiency through asset ownership is a virtue when private entities do it, how can it be a vice when governments do it?

Moreover, if the income that a government currently gains from taxation is equal to the income from a certain portfolio of assets, should not that portfolio have the same market value as the right to impose the taxes, so that the government, without resorting to any form of compulsion, could buy the portfolio by surrendering the taxation rights? We answer in the affirmative.

2. Theory

2.1 All taxes fall on rent.

Suppose that all entities (individuals and firms) located entirely within a certain zone were exempt from tax. The exemption would induce a net migration of taxable entities into the zone, driving up the rents (hence prices) of land in the zone until the rent premium (or interest premium) cancelled the tax advantage, at which point the net migration would cease. This "rent premium" is the difference between the rent of land inside the zone and the rent of comparable land outside the zone. If the zone were very small, the effect of the migration on land rents outside the zone would be negligible, so that the rent premium would be almost entirely manifested as a rise in rent within the zone. Moreover, even if the zone were larger or of no fixed size, the overall supply of land is still fixed. From the viewpoint of taxpayers, the supply of land zoned for any particular purpose is also fixed, as is the supply of land within acceptable distance of any particular services, infrastructure, or markets. Consequently any increase in effective demand for land, including that caused by the tax exemption, cannot be offset by increased supply, but can only be manifested in higher rents, so that the rise in rent inside the zone of exemption will not be balanced by a fall in rent outside the zone.

It follows (at least to a first approximation) that taxes paid by tenants are simply deductions from the rent that the landlords could otherwise get for the land. The effect is on land rents, not building rents, because the values of buildings are limited by construction costs, while the value of land reflects the value of its location even if no buildings yet stand on it.

2.2 All deadweight costs fall on rent.

Taxes reduce the returns on the taxed activities. This is true not only of the taxes themselves, but also of the associated compliance burdens ("paperwork") for the private entities that pay and/or collect the tax. (In the Australian States, payroll taxes are especially resented for their compliance costs). The reductions in returns cause some otherwise viable transactions, and hence some otherwise viable enterprises, to become unviable. The net cost of these opportunities is the so-called deadweight cost of taxation.

Under the aforesaid exemption, the "tax advantage" of being located in the designated zone is not limited to the actual tax saved, but also includes the additional opportunities opened up by the lifting of the tax burden; that is, it includes the removal of the deadweight cost.

It follows (again to a first approximation) that the deadweight costs of taxes on tenants are simply deductions from the rent that the landlords could otherwise get for the land.

Compliance costs incurred in cash are part of the income of other entities and contribute to the ability of those entities to pay rent. Such compliance costs are therefore not of themselves deductions from rent, although they contribute to deadweight costs which are deductions from rent.

For the same reason, compliance costs incurred in cash are not net losses to society, although they are net losses from the viewpoint of a single taxpaying entity. Hence they cannot of themselves constitute deadweight, although they are causes of deadweight. Accordingly, this paper treats deadweight as being net of compliance costs, so that, from the viewpoint of a single entity, deadweight costs and compliance costs are additive.

2.3 Less tax: more revenue?

We have seen that taxes paid by tenants, together with their deadweight costs, are deductions from the rent that the landlords could otherwise get. In the case of owner-occupants, who are both tenants and landlords, the implication is that the taxes and their deadweight costs are deductions from the imputed rent of the land; but this is even more obvious, as imputed rent is simply the benefit of owner-occupancy. In general, then, both the taxes and their deadweight costs are deductions from the rental value of the land, whether the land is actually "rented" or not.

If the taxes were avoided, the rental value of land would increase by a margin equal to the avoided taxes plus the avoided deadweight costs, i.e. by more than the avoided taxes. Hence, if this additional rent were somehow captured for public revenue, it would more than compensate for the avoided taxes while leaving the land owners no worse off. Alternatively, if enough of the additional rent were captured to compensate exactly for the forgone taxes, the land owners would be better off.

3. Implementation

Because this paper deals with the revenue of an Australian State, and because local governments in Australia are completely subject to their respective State governments, the word taxation and its relatives, unless otherwise qualified, will henceforth refer to State and local taxation. The usual academic distinction between taxes and charges will be retained: taxes are unrequited whereas charges are apportioned to particular services rendered.

3.1 Shared equity; shared tenancy

Suppose that the State offers "you" (a tax-paying entity) a tax exemption on the condition that you surrender to the State a fraction f of the equity in all land that you own and of the tenancy of all land that you occupy, where the value of f is negotiable (but applicable to any new piece of land that you acquire or lease in future). As the State does not actually occupy the land, this means you must pay a fraction of its rental value to the State in compensation for the State's share of the equity or tenancy. So the proposed tax exemption is a tax/rent swap. If we take the value of the land as the rental value as seen by a landlord — that is, the rent that would be paid by a tenant to a landlord for the use of the land — then this value will not be greatly affected by any fair tax/rent swap, because the rent share paid by a tenant to the State would be a substitute for tax, so that the change would not greatly affect the tenant's willingness or ability to pay rent, while the rent share paid by a landlord to the State would also be a substitute for tax, so that the change would therefore not greatly affect the price (or interest thereon) that a prospective landlord would be willing and able to pay for the land. So let us take this rental value as the value of the equity or tenancy of which the fraction f is surrendered to the State [1].

We shall now show, by means of a little algebra, that there is a range of values of f for which the proposed deal would be mutually beneficial and would therefore proceed.

Let R be the total rental value (as seen by a landlord) of all the land that you own or rent (this would be known from, e.g., valuations for municipal rates and State land tax). Let T be the tax bill that you stand to avoid, C the compliance cost that you stand to avoid, and D the deadweight cost that you stand to avoid, all quantities being expressed per annum.

Then the deal is attractive to you provided that the benefit exceeds the cost — i.e. provided that

where, again, the benefits are written on the left and the costs on the right, but from the State's point of view.

The two conditions are compatible because C and D are missing from (2). In practical terms, that means they are compatible because the deal gets rid of your compliance cost and deadweight cost, leaving a net benefit to be divided between you and the State.

where the middle expression (fR−T) is recognizable as the net benefit to the State.

Now notice that there is always a range of values of f that satisfies (3). At the maximum value of f, condition (3) becomes

so that the State gets the whole benefit of the removal of compliance costs and deadweight costs (C+D). At the minimum value of f, condition (3) becomes

so that the State gets none of the benefit (i.e., you get it all). So the fraction f will be negotiated to give a mutually acceptable division of the benefit, and the deal will go ahead.

The foregoing analysis is slightly optimistic in that it fails to allow for the taxes currently paid by the private beneficiaries of your compliance costs in consequence of those costs. This means that the benefit to be divided between you and the State, as seen by the State, is somewhat less than C+D, but still greater than D alone (because the beneficiaries of C do not pay all of it in tax). But this does not alter the fact that there is a net benefit to be divided between that taxpayer and the State, hence a range of values of f for which the benefit will be mutual.

3.2 No fiscal deficit

The State's share of the benefit means that each deal will be revenue-positive. That guarantees that there will be no "black hole" in the State budget in consequence of this reform. A separate macroeconomic calculation demonstrating that the budget figures "add up" is neither necessary nor possible, because all the "adding up" is done on the microeconomic scale, one deal at a time.

A consequence of the State's share of the equity or tenancy is that the rent paid to the State will increase if the value of the land increases, e.g. due to rezoning. Inasmuch as this fact will reduce the fraction f that the taxpayer is willing to offer, it will also reduce the fraction that the State needs to receive. So it does not cause any fiscal problems. Nor does it cause any injustice, because both parties know about it and neither is forced to close the deal.

Because the rent shares paid to the State are meant to replace both State and local taxes, a fraction of the rent received by the State from land in each local government area would need to be refunded to the responsible local council. The council would still be able to supplement this revenue with per-unit service charges, which are not meant to be replaced by the shared-equity/shared-tenancy system.

3.3 The case of owner-occupied land

Because R in the above analysis refers to the total value of land that you own or occupy, any land that you own and occupy is counted twice, so that each case of ownership or occupancy is counted once. But because f is negotiable, the effect of this "double-counting" is not to increase the rent that you pay to the State, but rather to reduce the value of f that leads to a mutually acceptable rent share. In general, then, each piece of land is associated with two values of f: one for the owner and one for the occupant. But for owner-occupied land, these values are the same.

In the case of owner-occupied residential land, it would be possible to defer any increment in the rent payable for the State's share, allowing it to accumulate as a lien against the land until the next transfer of title, and capping the lien to some fraction of the increase in the real value of the land since the last transfer. Ordinary owners who joined the new system would then be protected against increases in their recurrent rent bills (which is not necessarily the case with municipal rates under the present system). It would even be possible to defer the whole of the rent in this manner, in which case ordinary home owners would no longer get periodic bills for property taxes (such as the present bills for municipal rates).

To maximize the benefit for home owners, the property taxes to be replaced by rent shares should include not only municipal rates, but all recurrent taxes that fall on property owners as property owners. These include water connection charges (not consumption tariffs), sewerage and drainage connection charges (not discharge tariffs), and garbage/waste charges. (In New South Wales, all of these are imposed by local governments). These charges are unnecessary because the availability of the associated services adds value to the serviced land, so that the services can be funded by capturing part of the land value — as the shared-equity system does. The charges are also undesirable in so far as they tend to increase with the quantity of accommodation provided, and therefore discourage the construction of housing and reduce its affordability.

3.4 Coexistence of two systems

Entities under the new system — that is, entities that have accepted tax/rent swaps, granting shared equity and/or shared tenancy to the State in lieu of taxes — would not remit taxes to the State. But they would still bear any indirect taxes (e.g. payroll tax) hidden in prices that they pay. Over time, these hidden taxes would be reduced as other entities joined the new system and thereby gained exemptions from remitting indirect taxes.

Almost all taxes have exemptions, which in turn may require rules concerning the interaction between a taxed entity and an exempt entity. If the exempt entity is exempt by reason of a tax/rent swap, no additional complication arises.

3.5 Scope of "land"

The market value of a piece of "land" includes the value of any building rights conferred by the planning or zoning system, and of any other privileges attached to the "land" or building(s), because all these things affect the potential rent stream. To allow for this, the category "land" must be generalized to include sites — that is, pieces of ground or airspace, including any attached rights to build on that ground or into that airspace or to use the ground or buildings for particular purposes, but excluding any actual buildings.

[Note: The rest of this subsection would affect only a minority of taxpayers.]

When we say that the rise in spending power conferred by a tax exemption would be converted into a rise in the rental value of land, it is critical that taxpayers cannot produce more land or bring more land into the taxing jurisdiction; if they could, the additional supply of land would restrain the increase in rent. This indeed is the essential economic property of sites: taxpayers can neither create sites nor move them into (or out of) the taxing jurisdiction. But sites are not the only assets with this property.

Consider taxi licences, also known as plates. In Australia, taxi plates are issued by State governments and are usable only within their respective States (or specified parts thereof). They cannot be created by taxpayers or moved into or out of the issuing States. So for economic purposes they are site-like. For a taxi operator per se, the one indispensable site-like asset is not a site, but a plate. Hence any tax advantage conferred on taxi operators would tend to be competed away, not in the rental values of sites, but rather in the rental values of plates. If plates were not assessable in the tax/rent trade-off, taxpayers in other lines of business could opt out of the present tax system and then switch to the taxi business, raising the non-assessable rents of plates and lowering the assessable rents of sites, causing a net loss of revenue.

So, if the thesis that all taxes and all deadweight costs fall on the rent of "land" is to be strictly true, and if leakages of revenue are to be prevented, the category "land" must be further generalized to include all site-like assets — that is, assets that taxpayers can neither create nor move into (or out of) the taxing jurisdiction.

When the "taxing jurisdiction" is an Australian State, site-like assets include not only sites and taxi plates, but also gaming licenses, seaport time slots, easements, rights of way, pollution rights, water rights, fishing rights, and forestry rights. As many of these assets as are tradeable have observable rental values (or lump-sum values from which equivalent rental values can be calculated) and can therefore be counted as "land" for the purpose of tax/rent swaps.

But most taxpayers, especially individuals and small businesses, would not be affected by "site-like" assets other than sites.

3.6 Factors affecting f

A negotiable value of f is needed only to ensure that existing taxpaying entities do not suffer loss on entering the new system. New entities, or newly taxpaying entities, could simply be assigned a standard value, which would be enshrined in legislation and based on long-term revenue requirements.

Because the Revenue Office would not be obliged, financially or politically, to bring any particular taxpayer into the new system, it could afford to drive a hard bargain when trying to ensure that the entry of a taxpayer into the new system would not cause a loss of revenue. In particular, because property is presently taxed more heavily through transfer taxes (stamp duty and development levies) than through recurrent taxes (e.g. land tax and rates), close attention would be paid to property investors with relatively static holdings, who may have paid little tax in the past, but who can be expected soon to realize large capital gains that would have incurred substantial transfer taxes under the old system. If such taxpayers wanted to join the new system, they would need to surrender higher equity fractions than their asset values and past tax payments would suggest. In such a case the Revenue Office would be acting somewhat like an insurance company, seeking an increase in its equity fraction as an insurance premium against the risk of future asset transfers. In an extreme case, e.g. of a taxpayer holding a large portfolio of idle land, the Revenue Office might not accept the taxpayer into the new system until the idle assets were either fully utilized or disposed of.

The opposite situation would arise with (e.g.) a major employer that has paid a large amount of payroll tax by comparison with the value of land that it uses. To continue receiving the same revenue from this taxpayer, the Revenue Office would need to demand an anomalously high f. The taxpayer might well ask why it should be penalized for creating employment. Of course the same question could be asked even more forcefully under the present system, in which the tax is actually on employment! However, as the new system would encourage economic growth (see below), hence growth in land values, hence growth in revenue, it would be possible first to cap f and then to reduce the cap. Because every taxpayer under the new system would be characterized by a single value of f, and because this value would be a historical relic bearing no apparent relation to capacity to pay, the political case for reducing the top value of f (while leaving lower values unchanged) would be very easy to make.

4. Economic benefits

4.1 Advantages for enterprises

If your enterprise accepts a tax/rent swap, it avoids substantial compliance costs and deadweight costs. Most taxes and some compliance costs are marginal costs (that is, they increase with turnover), and therefore must be recovered through prices if your business is to grow. This is obviously an impediment to growth — that is, a cause of deadweight. In contrast, rent is a fixed cost (that is, independent of turnover). If you accept a tax/rent swap, thus replacing a marginal cost (tax) with a fixed cost (rent), you gain an advantage in the contest for market share.

4.2 Lower unemployment without inflation

Indirect taxes, notably including payroll tax, feed into prices, thus increasing inflationary pressures and raising the so-called natural rate of unemployment, which is the minimum unemployment rate that causes enough wage restraint to give stable inflation. The central bank adjusts interest rates so as to maintain unemployment at this "natural rate".

But, as more and more entities accepted tax/rent swaps, fewer and fewer would remain subject to the inflationary taxes; so inflationary pressures, and therefore the "natural rate" of unemployment, would fall.

If the reform were confined on one State, the effect on the nationwide natural rate of unemployment would be diluted, but so would the effect on the nationwide actual rate. Thus a single State, by financing its expenditure through shared equity and shared tenancy, could reduce its own unemployment without provoking a counterattack from the central bank.

4.3 Trade surplus; falling foreign debt

When taxes feed into prices, they feed into prices of exports and import replacements and thereby damage international competitiveness. By raising the cost of living, they also affect wage outcomes, with further consequences for export prices.

Shared equity and shared tenancy, by removing a range of taxes that feed into prices, would improve the competitiveness of the local products, helping the nation to trade its way out of debt.

4.4 Benefits for property owners through infrastructure

The land-equity shares and land-tenancy shares owned by the State would give the government an incentive to do things that increase the rental value of land — such as spending money on infrastructure. The fractional rent received by the State through land owners would not be at the owners' expense; it would be additional rent generated by the elimination of taxes. Because of the fixed proportionality between the land owners' rents and the State's rents, the new infrastructure would increase both, delivering a benefit to the land owners. In most cases this benefit would not be delivered under the present system, because the infrastructure would not be built!

Because a fraction of the rent received by the State in each municipality would be returned to the municipal council, the council would also have some incentive to invest in infrastructure within its field of responsibility.

4.5 Bonanza for professionals

Numerous entities contemplating radical optional rearrangements of their tax affairs would obviously generate much business for the professionals who facilitate such rearrangements or give advice thereon. The Revenue Office would also need actuarial advice in its negotiations with taxpayers. Property owners who accepted tax/rent swaps would see property in a new light — not only as a source of capital gains and (real or imputed) rent, both augmented by public expenditure on infrastructure, but also as a holding cost (the fractional rent bill accepted in lieu of the tax bill). Hence, while increased expenditure on infrastructure would make property investment more profitable, investors wishing to take maximum advantage would need to rationalize their holdings, either generating income from their properties or selling them to others who would generate income from them. That would generate much business for the property transaction industry.

4.6 Affordable accommodation

While rents received by landlords under the new system would increase due to improved infrastructure and faster economic growth, this does not mean that accommodation would be less affordable, because affordability depends not only on the rent or price, but also on the amenity of the accommodation, which is improved by infrastructure, and on the spending power of tenants and potential buyers, which is improved by economic growth. To see the combined effect on affordability, one must consider the competitive position of tenants and potential buyers. By encouraging landlords to generate income from their properties, the shared-equity arrangement would stimulate construction of new accommodation and make landlords less tolerant of vacancies. The improved supply of accommodation would reduce the intensity of competition between tenants and between potential buyers. On balance, then, accommodation would become more affordable, although rents and prices would increase in terms of raw dollars. To claim that both landlords and tenants would gain, or that both buyers and sellers would gain, is not a contradiction, because the promotion of economic growth is not a zero-sum game; it is analogous to making a bigger cake so that everyone can have a bigger slice.

5. Enabling legislation

The legislative embodiment of the shared-equity/shared-tenancy system of State revenue would be unusually simple. The essence of it would be contained in a single sentence such as the following:

Of course some definitions would also be needed. The types of "assessable assets" would need to be enumerated; these would be "site-like" assets as described above. The authorities for asset valuations and (where necessary) the discounting rates for converting between capitalized asset values to rental values would need to be specified.

The optionality of the scheme has two far-reaching implications for the enabling legislation:

5.1 Political feasibility

Any real or imagined objection to the shared-equity/shared-tenancy system is adequately answered by the fact that participation would be optional. No one would be harmed by having the choice of staying in the present tax system or escaping from it. Any opponents of the reform would have to explain why they want to impose the status quo and deprive the people of choice.

Hence, if a political party were to be established on a platform of financing State and local governments by shared equity and shared tenancy, the platform could not be easily attacked. Nor could it be easily characterized as a "single-issue" platform, in view of the numerous pernicious effects of the existing tax regime and the corresponding benefits of replacing it. Such a party could therefore be expected to attract a substantial following, forcing the major parties to pay attention.

6. Conclusion

If a taxpaying entity could avoid State taxes (including local taxes) by granting the State a negotiated fraction of the equity in all land-like assets that it owns and of the tenancy of all land-like assets that it occupies or uses, both taxpayers and the State would be keen to take up the offer. The damaging effects of taxation on the economy would fall in synchronism with the number of entities remaining in the old tax system. Thereafter, the State would finance its expenditure not from taxation, but from rent shares, which the government would effectively have purchased by giving up its taxing powers.

Notes

[1] As the rental value seen by a landlord is insensitive to tax/rent swaps involving the State government, it is also insensitive to tax/rent swaps involving any other tier of government. So this measure of value allows taxation to be replaced by shared-equity and shared-tenancy schemes not only at one level of government, but at all levels.

Revision history

Version 2007.03.07 (considered a draft) is the original. It draws heavily on Working Paper No.2, which in turn is expected to be revised in the light of this paper.

The possibility of a Zero-Tax Party in New South Wales

Contents

1. Sauce for the goose...