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Ad Valorem Taxes


Nic Tideman: Land Taxation and Efficient Land Speculation

Taxes on the Sale Value of Land

A tax on the sale value of land, or "ad valorem" tax, is a recurring (e.g., annual or monthly) tax proportional to the price at which the land would sell. Ad valorem taxes on land have been praised by many economists for the fact that they do not impair incentives to use land productively. The characteristic of an ad valorem tax that keeps it from impairing incentives to produce is that, when such a tax is properly administered, the amount of the tax is independent of any action taken by the taxpayer. Whatever course of action maximizes the wealth of a taxpayer before a tax is levied also maximizes his or her wealth after the tax is levied (apart from income effects, which do not entail allocative distortions). A taxpayer can reduce the taxes he or she pays by selling the land, but the new purchaser will acquire a tax burden of the same magnitude. The total of taxes to be paid is independent of any reshuffling of land titles among taxpayers. For this reason, ad valorem taxes on land, like taxes on the rental value of land, are capitalized into the purchase price of land and entail no economic distortions.

A tax on the sale value of land is very much like a tax on the rental value of land, but with a somewhat different incidence. If land is not taxed, its sale value in a market in which the participants foresee the same opportunities can be described as the present value of future net returns, discounted at the market interest rate, r, when the land is used in such a way as to maximize those returns. The effect of an ad valorem tax at an annual rate of t is to increase the annual holding cost of a dollar's worth of land from r to r + t. Thus the value of a site in the presence of a tax at a rate of t is computed by discounting future returns at a rate of r + t. The sale price of a site with a net return of x per year falls from x/r to x/(r + t), so the tax takes the fraction t/(r + t) of the pre-tax value. Thus for land that is not changing in value, an ad valorem tax at a rate of t is equivalent to a tax at a rate of t/(r + t) on the rental value of the land.

If the net return from the use of a site is not constant but rather grows from an initial value of x at a rate of g, then the sale value of the site in the absence of a tax is x/(r - g). When the tax raises the annual holding cost to r + t, the sale price becomes x/(r + t - g). The fraction of value that is taken by the tax is t/(r + t - g). For example, if the tax rate is 4% and the interest rate is 8%, then the tax takes 1/3 of the value of a site that is not growing, but 40% of the value of a site whose return is growing at 2% per year. When paths of returns through time cannot be expressed as simple growth rates, it continues to be true that, other things being equal, a site with relatively more attractive future prospects will bear a higher proportion of current taxes under a tax on the sale value of land than under a tax on the rental value of land. Thus an ad valorem tax falls more heavily on land that might be the object of speculation than on other land. It thus tends to discourage speculation more than a tax on the rental value of land does. Otherwise, its effects are the same as those of a tax on the rental value of land. There is an upper limit of 100% on the feasible rate of a tax on the rental value of land. There is no such upper limit on the feasible rate of an ad valorem tax on land. The tax could be 10% per year or 10% per day or 10% per hour, with the sale value falling as the rate rose. In the limit as the tax rate of an ad valorem tax approaches infinity, the tax approaches a tax that takes 100% of the rental value of the land.

An ad valorem tax is administered by having assessors who estimate the sale value of land. When tax rates are modest, it is easy enough for assessors to do this by monitoring sales of land that is vacant or has only structures that are about to be demolished. However, if the rate of an ad valorem tax is very high, then the influence of inherent value of land will be overwhelmed in prices by idiosyncratic features of transactions between particular buyers and sellers. Assessors would need to rely on processes in which sale prices were linked directly to taxes. These could be either auctions, where participants knew that the auction result would be used to set the tax for a specified period, or options, where potential uses of land offered specified payments for any site meeting certain standards. Because ad valorem taxes on land have no distorting effects, they neither retard nor advance the timing of land development in a world of perfect information. This has been denied by Shoup (1970, p. 38-39), Bentick (1979, pp. 861-63; 1982) and a variety of other writers who have followed them. The tax that Shoup and Bentick analyze, however, is not an ad valorem tax, but rather a tax whose base is the present value of the future net income that is expected to result from the plans for a site. Thus a change in the plan produces a change in the tax bill, generating an incentive for inefficient changes in plans (Tideman, 1982). ... read the whole article




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Wealth and Want
... because democracy alone hasn't yet led to a society in which all can prosper