Monday, July 20, 2009

Economic 20/07/2009: Property Tax

And by request from one of you, an earlier Sunday Times article (July 12, 2009) on property tax:

A specter of a new tax is haunting Ireland. Since last October, the Government has been pre-occupied with finding increasingly less subtle ways to raise revenue out of the shrinking economy. The latest Department of Finance estimates put new ‘committed’ tax measures envisioned for 2010-2011 at €4.6bn – one and a half times more than is planned in expenditure cuts.

Per latest rumours from the Commission for Taxation, the most favoured new scheme being discussed in the corridors of power is a property tax. A source close to the Commission has indicated to me last week that this month’s report will recommend replacing the stamp duty with a levy on residential and commercial properties. Another source – this time from the Upper Merrion Street – voiced a serious concern that the Government is leaning in favour of “a quick and regressive property tax grab”. When civil servants start labelling a new tax prospect as a “regressive” policy”, one has to be concerned.

The problem is that a property tax is an economically inefficient way for addressing our long-term tax reforms objectives. To see this, consider the reasons as to why our existent structure of taxation in Ireland has to be overhauled.

To date, our taxation system has relied excessively on pro-cyclical tax sources: stamp and excise duties, VAT and assets-linked levies. This has contributed (alongside with gross over-expansion of the public sector) to a full-blown crisis of insolvency in this state.

In H1 2009 total returns from capital gains and acquisition taxes (CGT and CAT) were 74% down on their peak in H1 2007. Stamps fell 80%, VAT - 23.5%, while excise duties were off 26%. Of the €5bn shortfall in total tax revenue in the first six months of 2009 relative to the peak year of 2007, €4.7bn was accounted for by the property, capital and consumption taxes.

Assuming the property tax replaces the two-three year average revenue from stamps – in order to compensate the Exchequer at least in part for some revenue declines – the amount of tax to be raised would equal to €2.4-2.9bn against the current revenue of €680-700mln. In other words, property taxes simply cannot resolve the problem of financing the Exchequer deficit until at least there is a dramatic improvement in the economy.

What is more problematic, however, is that our tax system yields are highly volatile and unpredictable. This is linked to stamps and consumption taxes, with the former having by far the largest impact on revenue deviations from the long-term trend. Stamps are transaction taxes that normally act to reduce overall variance of asset prices and thus dampen down market bubbles – the so-called Tobin tax effect. Normally is the operative word here, for when the underlying assets is infrequently traded, like housing, transactions taxes have the exactly opposite effect, contributing to bubble inflation, rampant speculation and producing extreme peak-to-trough deviations in revenue. This makes future changes in tax receipts less predictable and thus hinders expenditure planning.

A property tax will only partially address the issues of predictability and volatility as it will be directly linked to collapsing property prices. And it will not reduce the propensity for speculative investment in real estate, thereby doing nothing to prevent bubbles in property markets. International experience shows this to be the case, as are the simulations for a property tax in Ireland.

Instead, a site value tax can be used more efficiently to smooth real estate price cycles and to introduce a system of revenue falloff warnings, because land values tend to move change slower over time in functional real estate markets than property prices. For example a simple site value tax, along the lines of the one used in Denmark and Hong Kong, can provide up to 10-12 months delay in decline in revenue relative to other tax heads in a recessionary cycle. Such a tax would apply to all land, including residential property, and can be set at rates that would encourage more efficient and environmentally and spatially more sustainable development in the long run.

In the case of Ireland, my simulations show that a land value tax, raising equivalent of the stamp duties revenue at the peak of the growth cycle in 2006-2007, would have reduced Government revenue shortfall by approximately 35-40% until roughly the end of Q4 2008 – delaying the onset of the fiscal crisis by some 9-10 months. The same tax would have fully smoothed out tax revenue volatility in previous two downturns.

In the long run, our reliance on income and consumption-related taxation is starting to adversely impact Ireland’s ability to attract highly educated and young labour force. This imperils our ambitions to develop a knowledge-intensive high value-added trading economy. In H1 2007, income tax and VAT accounted for 64% of all revenue. By 2009 this figure stood at 70%. Property and capital taxes have seen their share of overall tax burden collapse from 14% to 4% over the same period of time. In other words, thanks to our economically illiterate system of taxation, we are now subsidising property speculators while destroying more productive households. Some 83% of all taxes collected since the beginning of the current downturn accounted for by income tax, excise duties and VAT (up from 76% in 2007).

Shifting more tax burden from physical capital stock onto our incomes and consumption – as a property tax would do relative to the site value tax – will lead to two long-term damaging developments. An increased tax burden will disproportionately befall those amongst us who possess greater human capital and destroy the savings and investment capacity of our younger generations.

A property tax, applicable to the value of one’s residence or office will also act to increase the cost of more efficiently used facilities, putting further pressures on income of the more productive segments of our population. A land value tax, in contrast, will raise more funds out of the under-utilized speculative land and property holdings, increasing relative returns to more efficient, sustainable and demand-driven development, thus in the long run improving housing and commercial real estate markets and costs.

A property tax will hinder any realistic chances of us transitioning to a more environmentally and economically sustainable development model, incentivise further sub-urban sprawl and destruction of community social capital. It will also reward, in relative terms, those who let their property fall into disuse or disrepair. For example, for two neighbours residing in otherwise identical residences, higher taxation will apply to the one who adds an extension to her dwelling or improves insulation on the house, thus allowing for a more efficient use of our housing stock resources.

Should the city or a local authority provide new infrastructure to the neighbourhood, thus increasing the value of the land in the area, once again a property tax will hit the hardest those of the neighbours who put most effort into their property, leaving brown sites and underutilised property owners largely unaffected.

A comprehensive research study into the optimal infrastructure-financing tax systems, published this week by the University of Minnesota found conclusively that a land value tax is a unique measure for directly linking private returns to public investment and the Exchequer tax revenue. A property tax, in contrast, will yield higher private gains to less economically and environmentally sustainable forms of development and property ownership, preventing proper payment for the private benefits of public investment by property owners.

In short, introducing a property tax in place of a more progressive land value tax will be an opportunity lost to create a more equitable, economically sustainable and efficient system of taxation in Ireland.

Box-out: In response to my note on June 14 here, a recent editorial in the Irish Times (Friday, July 3) by Cathal O’Loughlin claimed that if the €10 per passenger travel tax passed into Budget in April were to induce some Irish households to stay away from vacationing abroad, there will be net gains for Irish economy.

Mr O’Loughlin’s arguments fail in terms of simple data analysis. Current data shows that in Q1 2009 relative to Q1 2008, Irish economy has lost 148,000 visitors travelling here from abroad for more than one day, it might have gained some share of the 231,000 Irish residents who decided not undertake a trip abroad. Given seasonality in travel demand, the split between business and other travellers, the latter share is likely to be in the range of 30-40%, as at least some of our potential travellers would opt to take discretionary breaks in their second homes or staying with friends and relatives instead of surrendering to the rip-off prices in our hospitality sector. Do the math: 140,000 foreigners gone, about 70-90,000 domestic travellers holidaying at home. Net gains for the travel sector?

Mr O’Loughlin further confuses the effects of imports and exports of services on the domestic economy, when he simplisticly claims that any Euro ‘saved’ from travelling out of Ireland is a Euro spent in Ireland and when he asserts that such a spending turn-about has the identical net economic effect to every Euro in spending by the foreign visitors here.

The sheer economic illiteracy of Mr O’Loughlin’s argument in favour of a tariff protection of an internationally traded domestic sector is stunning and has been refuted by the entire body of international trade literature. Not surprisingly, every developed country in the world has resisted raising such charges on travel in the current downturn, and many have lowered them.

1 comment:

James Young said...

I remember someone who wrote for the Independent a few years ago suggesting the lowering of the stamp duty in favour of a property tax based upon a percentage of assessed value. That could have slowed the bubble, forced more efficiency in housing tenure choices, and created a tax base not so heavily dependent upon transactions. Introducing a property tax now and under these circumstances is insanity....