PROPERTY TAX

A change in the taxation system offers another way of creating pressure for efficiency. In the current system of income taxes, whoever produces more pays more. As a result, efficient managers who produce more have to share the gains from their efficiency with the government through higher taxes. The government also absorbs (through lower taxes) a fraction of the losses of the incompetent. But this favors the inefficient. Those who waste resources in lavish and extravagant expenses or who make unsound investments are subsidized by the taxation system, which absorbs part of these expenses or losses, while efficient managers are penalized because part of their superior returns goes to the government.

Not all taxation systems have this effect. A tax based on property (not income) tends to penalize the inefficient and reward the efficient. To see this, consider a tax of 1 percent levied on all productive assets that a person directly holds. The tax due on farmland worth $1 million would then be $10,000. Suppose a would-be author from the city who likes rustic surroundings but has little ability to farm can produce only $5,000 in net income from this land. All her farming income will be taken by the government, and she will have to find an equal amount elsewhere. If her books do not sell or she cannot lobby for farm assistance, she will have to sell her land to someone who can do a better job of farming it.

Contrast her with a son of the soil who knows his farming and earns $100,000 from a similar piece of land. Only one-tenth of his income will be paid in taxes. More important, if he improves the productivity of his fields and increases his income to $150,000, he retains all the gains rather than only a fraction of them as under an income tax system. Moreover, he can expand by buying the city dilettante’s land. The son of the soil has less of an incentive to lobby for farm subsidies or for trade barriers against foreign products: subsidies will keep the dilettante in business, preventing him from expanding, and trade barriers will invite retaliatory barriers that will prevent him from selling his grain abroad. In this way, a property tax favors efficient producers and helps strengthen promarket forces.⁴

Some readers may wonder why a free market in land will not lead to the efficient allocation of resources. In other words, why does the efficient son of the soil not buy out the incompetent writer? The problem is that the writer gets psychic nonmonetary value from the land that makes up for her incompetence at farming. This psychic income is not taxed. As a result, even if her psychic income does not make up for the lost monetary income, the son of the soil will find it hard to buy her out. Under the current tax regime, psychic income is tax exempt while anyone who produces monetary income faces the full burden of taxes. So everything else being equal, the producer of monetary income is willing to pay less for a piece of property than one who enjoys psychic income from it. Similarly, the current tax regime subsidizes the survival of incompetent businessmen who get personal value from running their firms. A change from taxes on the income generated by property to a tax on the value of property itself will avoid these inefficiencies.

There are, of course, issues about how such a system would be administered. For example, how would the value of property be measured? It cannot be measured as the value of assets under the current inefficient producer’s control, for that would artificially depress the value and hence the taxes she would pay. To avoid rewarding incompetence, the value should be measured as a notional market value under average alternative management. There are ways of making these values quite precise. We do not see the problems in administering a system based on property taxes as significantly greater than the complexities of administering one based on income taxes.

Traditionally, the argument against a property tax has been that it discourages investment. Under certain assumptions about the timing of the tax, this is true: for a given level of tax revenues, a property tax reduces the incentive to invest more than does an income tax. This should be set off, however, against the benefits of a property tax system in allocating ownership to more efficient hands, which contributes both to the general well-being of society and to the stability of the free market system. Thus, it makes sense to shift at least some of the tax burden from income to property.