David Ricardo must be smiling in his grave, satisfied at having been vindicated so emphatically. The 19th century British economist said that a substantial portion of the wealth generated through any economic activity ends up as increased land value, benefiting only landowners, who are passive recipients of this windfall. In short, it’s an unearned increment for the owner.
Land values rise in leaps and bounds due to community activities such as new roads, transport links, other civic infrastructure, and often government-catalysed industrial and commercial development. All these activities, many of them public goods, generate a large amount of positive externalities, predominantly as increased land values. However, a major share of such benefits go to private landowners, without being shared with society.
We, therefore, have a situation where private individuals, fortunate enough to have land at the right location, enjoy a bonanza at the expense of ordinary taxpayers, whose taxes are used to fund these positive externalities. And the unkindest cut is that the taxpayer does not get any share of this massive wealth generation! It is a form of private appropriation of public value, embedded in increased land rents or values.
A typical story goes like this. Mr Realtor buys land in Realtyland. The government then announces its decision to set up a software park in the vicinity of Realtyland, causing land values to double. The software park is completed, and all basic infrastructure facilities, schools, hospitals, commercial centres and residential enclaves come up. The land prices now triple. What is Mr Realtor’s contribution to this growth? None! But he and similar landowners are the biggest beneficiaries of this boom! He then sells a part of his land and goes to Realtyland II and buys another 5 acres. The government then announces the setting up of an SEZ, and land values double. Replace any part of Hyderabad or any other city with Realtyland, and the numerous land nouveau riche with Mr Realtor, and you get real world examples.
Apart from concerns of natural justice, increasing land values distort economic incentives. Experience from across the globe shows that rising land prices lead to a huge increase in household debt as people borrow heavily to invest in the booming real estate market. It also results in a drop in savings as people, lulled by the “wealth effect” induced by higher land values, stop saving. Witness the American experience!
The attraction of rising land values leads to crowding out of investment in more productive enterprises, as short-term returns from it far outweigh other investment options. High land prices have an impact on housing rents, thereby inhibiting internal mobility within a country and balanced economic growth, as people and investors find it difficult to find affordable land in cities.
This situation (of market failure) calls for some government intervention. Ricardo had argued for taxing ownership and exploitation of natural resources, instead of taxing human effort and enterprise. Adam Smith said that such a tax would not distort people’s incentive to work, save and invest, and would also be fair. Unlike labour and capital, the quantity of land is fixed, and hence taxation would not reduce the land available in the market.
There are many ways of assessing a land tax. One approach is to tax land transactions. This is already being done, by way of stamp duty, and suffers from substantial evasion and pilferage. But this tax would be a deterrent on a valuable economic activity, and encourage people to evade detection of the transaction or report lower transaction values. Another method is to tax the capital value of the land on an annual basis. Still another model is to tax the annual economic rent, or the amount of money the land would generate if leased out for a year. These two approaches minimize market distortions. Besides, they are easier to levy and collect, since you cannot stash land away in a tax haven.
A land tax has many advantages. It will reduce hoarding of land and bring more land into circulation and, therefore, reduce land prices, making it affordable for more people to own land and housing. This will ensure more economically and socially beneficial use of land, by way of construction or agriculture, that would add value to the economy and promote development. The extra supply of land would reduce urban land and building rents, and accommodation costs for houses and businesses. This would also help reduce the urban sprawl. Such a tax will also help the government reduce the need for other forms of taxation that penalize enterprise and effort.
Critics of any such taxation plan will point out that land is also a store of economic value, and hence an attractive source of investment for those who earn their incomes through entrepreneurship and effort. So, would it not be unfair to tax landowners? The argument against this would be that, even accepting it, are we not right in incentivizing these investors to invest in other, more productive avenues?
Many towns and local councils in Denmark, Australia, South Africa, New Zealand and some US states have different variants of land tax. Instead of being a Central government tax, any land tax should be a decentralized one. Since all land taxation is generally vested with local bodies, it is only appropriate that any land tax be levied and collected by them. Such tax revenues can be used to finance local infrastructure expenditure and can be a substantial source of revenue for local bodies. Local bodies can dispense with property tax levied on buildings and can impose land tax on the land housing the building.
Gulzar Natarajan is a civil servant. These are his personal views. Comments are welcome at email@example.com