26/4/2012: Sunday Times 22 April 2012: Water and Property Taxes

Here's my Sunday Times article from April 22, 2012 (unedited version, as usual):

Years ago, I quipped that Ireland doesn’t do evidence-based policies, instead we do policies-based evidence. Current whirlwind of taxation initiatives is the case in point. These include the household charge and its planned successor a property tax, plus the water charge and its twin meter installation charge. These policy instruments are poorly structured, rushed in nature, and are not based on hard economic analysis.

Water is a scarce resource, even in Ireland. On the supply side, we have abundant water resources in some locations and bottlenecks where population concentrations are the highest and where the bulk of our economic activity takes place. Reallocation of water to reflect demand/supply imbalances is a political issue, and creation of a monopolized system of water provision is not an answer to this. More effective would be to encourage local authorities to sell surplus water into a unified distribution system. Coupled with a structural reform and consolidation of the local authorities, this approach will incentivise productive economic activity in water-rich, less developed regions and provide competitive pricing of water.

Water delivery infrastructure is free of political constraints, but faces huge capital investment and operational problems. These factors are determined by treatment and transmission systems, and water quality monitoring capacity in the system. Chronic underinvestment in these areas means that Ireland’s quality of water supply is poor and water losses within the system are staggeringly high. Delivering this investment is not necessarily best served by a centralized monopoly of water provision. Only pipe infrastructure should be a monopoly asset, charging the transit fee that will reflect capital investment and maintenance needs of the system. Treatment and part of monitoring network can be retained at the local level to provide for local jobs and income.

Water charges are the best tool for demand management, a system of incentives to conserve water at the household and business level, as well as the revenue raising to sustain water infrastructure. In this context, a water charge is the best policy tool.

Currently, we pay for residential water via general taxation. If the policy objective is to improve water supply systems and create more sustainable demand, water charges should replace existent tax expenditure. In addition, higher level of collections is warranted to allow for investment uplift. Current price tag is estimated around €1.2 billion. Of these, ca €200 million come from business rates which feature a low level of compliance. Assuming half the normal rate of M&A efficiencies from consolidating the system of local water authorities, factoring in a 50% uplift on businesses rates compliance and allowing for a 25% investment buffer, annual revenues from residential water supply system should be around €900-950 million. This is the target for revenues and at least 1/3 of this target should go to reduce the overall burden of income taxation.

To deliver on the above target, we can either conceive a Byzantine, and thus open to abuse and mismanagement, system of differential allowances, rates and exemptions. Alternatively, we can take the existent volume of residential water demand and extract from this current price per litre of water. This rate should allow a 10-15% surcharge to incentivise future water conservation and to finance investment in water supply networks. Use this system for 3 to 5 years transition period. Thereafter, the market between the local authorities will set the price.

The charge, should apply to all households consuming publicly-supplied water. For poor households who cannot afford the charge, means-tested social welfare payments should be increased to cover water allowance based on the family size and characteristics. Savings generated by some households should be left in their budgets. The resulting system will be ‘equitable’, and economically and environmentally sustainable.

A complicated pricing structure of exemptions and allowances, backed by a quango and a state water monopoly, will not deliver on any the above objectives.

A different thinking is also needed when it comes to structuring a property tax. The latest instalment in the on-going debate on this matter is contained in the ESRI report published this week. In the nutshell, the ESRI report does two things. First, it proposes an annual tax on the value of the property while applying exemptions for those with incomes below specific thresholds. Second, the ESRI report attacks the idea of a site value tax as being infeasible.

Both points lead to an economically worst-case outcome of a property tax that falls most heavily on younger highly indebted families, thus replicating the distortionary effects of the already highly progressive income tax.

An economically effective system of property or site-value taxes should be universal, covering all types of property and land, regardless of ability to pay. Why? Because a property or a site value tax offers the means for capturing the benefits of public amenities and infrastructure that accrue to private owners. These benefits accrue regardless of the households’ ability to pay. Low-income household facing an undue hardship in paying the rates can be allowed to roll up their tax liability until the time when the property is sold.

My own recent research clearly shows that a site value tax imposed on all types of land, including agricultural and public land, represents a more economically efficient and transparent means for capturing private gains from public investments. It is also the least economically distortionary compared to all other forms of property taxation. This is so because a land value tax increases incentives for most efficient use of land and decreases incentives to hoard land for speculative purposes. A traditional property tax, in line with that proposed by the ESRI, does the opposite.

With a deferral of tax liability for those unable to pay, a land value tax will bring into the tax net those who hold significant land banks and/or own large parcel properties, but who are not investing in these lands and are not using them efficiently. The system will allow older households to retain their homes, but will charge fair fees on the property value that has nothing to do with these households own efforts when the gains are realized either at sale or in the process of inheritance.

The ESRI argument against implementing a site value tax is that the lack of data and a small number of land transactions in the economy prevent proper valuation. This argument is an excuse to arrive at the desired conclusion of infeasibility of the site value tax. Ireland is starting property valuation system virtually from scratch. Thus, unlike other countries, we have the luxury of doing it right from the start. Compiling a database for land valuations is easier than for property valuations precisely because sites have much less heterogeneity than the properties that occupy these sites. In simple terms, value of property is determined by the value of buildings located on it, plus the value of the site. The former is much harder to value than the latter. The value of a specific site can be backed easily out of an average or representative value of the properties located within the vicinity of the site, plus by referencing directly specific attributes of the site.

As with the water charges, the property tax system must be designed not from the premise that the Government needs a quick hit-and-run revenue fix, but from the premise that we need a new approach to taxation. Such an approach should aim to reduce the burden of taxation that penalises skills, work effort, entrepreneurship and discourages households from investing in their own human capital and properties. Instead, the burden of taxation should be shifted on paying for specific benefits received and on privately accruing gains from public investments and amenities. In this context – both water charges and a property or a site value tax represent a step in the right direction. But to be effective, these policies must be structured right.

Charts:

Box-out:

Just when you thought the taxpayers can breath easier when it comes to the banks, the latest data from the Irish, Spanish and Italian authorities shows that the banks of the European ‘periphery’ have dramatically ramped up their holdings of their countries’ Government bonds. In 3 months through February 2012, Irish banks increased their holdings of Government bonds by 21%, Spanish – by 26%, Italian – by 31%. Back in late 2008 I warned that the banking crisis will go from the stage where sovereign debt increases will be required to sustain zombified banking systems, to the stage when the banks will be used as tools for financing over-indebted sovereigns, to the final stage when the weak nations’ sovereign debt will become fully concentrated within the banking systems they have nationalized. Sadly, this prediction is now becoming a reality. As GIPS’ banks increased their risk exposures to the Governments that underwrite them, German and French banks have been aggressively deleveraging out of the riskiest sovereign bonds. In Q1 2012, Portugal ranked as the second most risky Sovereign debtor in the world in CMA Global Sovereign Credit Risk Report, Ireland ranked seventh and Spain ranked tenth, with Greece de-listed from the ratings due to its recent default. This concentration of risk on already sick balancesheets of the largely insolvent banks is a problem that can reignite the Eurozone banking crisis.