How can government raise taxes most efficiently? Economists have written libraries on optimal taxation. They conclude that the best tax does not distort behavior or fall heavily on a particular group. Taxing cigarettes would distort behavior -- increasing cigarette smuggling or driving people to other habits; taxing people with blue eyes would be unfair -- they would protest.
INCOME, CONSUMPTION AND PROPERTY TAXES
Income taxes distort behavior: The more you earn, the larger the tax-bite on your last dollar earned. More importantly, people need to report their income, which is a pain for the law-abiding and an opportunity for evasion or avoidance for those unwilling to be "suckers".
The higher your potential tax bill, the larger the reward for evasion, which means that corporations and rich people pay accountants a lot of money to avoid taxes. Self-employed and informally employed people (eg, drug dealers) evade taxes altogether. (Some Swedish econmists estimate that households with one self-employed member underreport their taxes by around 30 percent.)
Consumption taxes are better on incentives ("consumption -- vs. saving -- is bad, so tax it"), but the reporting burden falls more heavily on fewer people. It's easy for businesses to collect a retail sales tax from customers, but hard to make sure the businesses send in the proper total. The Value Added Tax (VAT) increases honesty by comparing the cost of inputs that retailers report to the sales of outputs wholesalers report. Unfortunately, the VAT increases complexity.
Property taxes are relatively easy to administer and hard to avoid. The property register of owners and assessed values identifies who pays and how much to pay. Better yet, property taxes do not distort behavior: they do not vary with one's actions, job, habits, purchases, etc.
Property tax discriminates against recent buyers, since it's based on the property's assessed value (AV, the purchase price plus some inflation adjustments), which rises more slowly than the market value. (I am assuming that market values are rising.) Imagine two identical houses, side-by-side. The owner who bought her house in 1986 will have a lower AV (and thus property tax bill) than a new owner who bought the house next door in 2006, even though both houses have the same market value. This "distortion" is the result of an argument of fairness -- that people should not have their tax bills jump because of events beyond their control. (Changing the tax rate is an easy way to increase tax revenue with fixed AVs. That happens for income and sales taxes, but is less common for property. The claim is that fixed-income pensioners would "suffer" from increases, but all long-term homeowners benefit. New owners and those who pay other taxes are harmed, of course.)
In 2006, according to the Tax Foundation, Americans work for 116 days/year to pay local, state and federal taxes. 70% of the total comes from income tax, 20% from consumption taxes and 10% from property tax. What about social security and corporate taxes? Social security taxes are another tax on income. Corporate taxes are actually paid by people -- not corporations -- either through reduced income (as workers or shareholders) or higher prices (as consumers). This brings up the important notion of incidence, i.e., who pays a tax. First point: only people pay taxes, not corporations. That means that the one-half of social security that your employer pays for you is actually coming out of your pocket (through lower wages) or customers' pockets (through higher prices). The Congressional Budget Office estimates that 70 percent of corporate taxes are "paid" by workers and 30 percent by shareholders. Someone always pays -- either directly (e.g., sales tax) or indirectly (e.g., corporate tax).
So who pays property taxes? Property owners, of course. Does that mean renters pay no property taxes? No. They pay property taxes indirectly through their rental payments to investor/landlords. The bottom line is that only individuals pay taxes, and some pay them indirectly -- through higher prices or lower wages.
WHY PROPERTY TAX SHOULD REPLACE ALL TAXES
Relative to property taxes, income and consumption taxes create more distortions, more paperwork and single out those foolish enough to honestly report income and or expenditures. This latter point -- reporting -- is a small one in the Developed world but imagine trying to set up a tax system in a Developing country. How would it work? First, you need a widespread, honest and competent bureaucracy; second, you need citizens willing to declare income or expenditures (i.e., merchants reporting consumer expenditures as sales); third, they must have the ability to do the accounting. These features are hard to find in the Developing World.
Property taxes, on the other hand, are easy to understand, need only be collected once or twice a year, and -- as I mentioned above -- do not distort behavior.
WOULD PROPERTY TAXES WORK DIFFERENTLY?
In my optimal system there is good news and bad news. The good news is that you need not file a 1040 ever again, and you can forget about 7.25% or 8.5% surcharges on your shopping trip to the mall. The bad news is that property taxes would go up and fluctuate.
In California (where I live), Proposition 13 has limited property taxes to about 1.3% of a property's basis, its assessed value or purchase price, which is allowed to rise by 2% each year -- regardless of the property's actual, market value. Limits like Prop 13 would have to go if the government was going to collect all of its revenue through property tax. If government expenses vary, taxes will as well. If basis does not change, the tax rate will have to.
HOW WOULD THEY WORK?
If we set income and sales tax to zero and wanted to raise the same amount of tax revenue for the government, property taxes would go to 10-times their current level. (Average per capita taxes in the US: $10,200, of which $1,100 from property tax. For California, the numbers are $11,200 and $963. Tax Foundation figures for 2004.)
Before panicking remember that the switch should be revenue neutral, ie, total government taxes will not change. Also remember that removing distortions and broadening the base (so everyone pays property tax, directly or indirectly) can reduce the actual burden for current tax payers.
For example: Mr. A, B, and C are citizens. A and B pay $12/each in income taxes; C evades his taxes. All three pay $1 each in property tax ($27 total). If we used property tax only, they pay $9/each; A and B are better off ($9 is less than $13) because C has to pay his "fair share".
HOW TO CALCULATE BASIS
More interesting is the calculation of basis. The current system allows basis to rise by a small percentage each year. If all taxes were based on property, there is an incentive to minimize your basis. In the US, property owners often declare the real value (ie, sales price) because they must get loans to buy the property; a lower declared value would reduce the loan and require the buyer to bring more cash to the sale. In a Developing country, however, cash sales make it easier to reduce your declared basis.
I suggest therefore that the basis for property taxes be the minimum of either declared value or 90 percent of the average of declared values of 20-100 local properties (controlling for size, improvements, etc.) An owner declaring a property value of $250k when average value is $200k has a tax basis of $180k. Since there's no reason to under-report one's own value, everyone will tend to be honest (to get bigger loans, among other things) -- pushing the "declared" average closer to the true average.
Let's explore this further: A, B and C have property.
Basis...$250k..$350k..$360k.<-- 90="" average="" br="" of="">
A sells for $850k to D. The new figures are:
Total basis moves from $960k (250+350+360) to $1,430k (540+350+540) so tax revenues go up. D is happy because she pays less than her value. B is happy because his basis stays the same. C is less happy because his basis has gone up, but it's still less than his value. With a higher basis and the same tax rate, total taxes will rise; if the total is held constant, then the tax rate will drop. (The outcome depends on political budget factors I do not cover here.)
Some people will worry about the impact on people with fixed incomes, etc. Although their basis may not change, their tax burden may, if rates are free to fluctuate. If total basis is rising faster than government spending, however, the rate on a property with the same basis will fall.
1) This system would work in Afghanistan as well as NYC. It's also very progressive: Rich people in expensive/multiple houses would pay more than apartment dwellers. To reduce distortions, no property would be exempt. That means government, non-profit, church, etc. (Big lobbying problem there.)
2) If a property has a basis that's "too low", either because of fraud or long ownership, the government might audit properties with values less than, say, 40 percent of local value. The owner could be allowed to declare a higher value or the property could be put up for auction, with the winning bidder buying it from the owner (and readjusting the basis). The owner could buy it for herself, of course, but the price is likely to be far higher than if she declared a value that was, say, 90 percent of market price.
3) There is some good reason to tax activities that produce externalities (eg, a carbon tax or sin tax) to reflect the "true costs" of that activity. That's anther discussion.
Sept 15 Addendum: Today, I read a paper by Fred Foldvary that proposes a "Geo-Rent" on land only. My proposal differs by taxing land and improvements. I prefer my version because it is more progressive (valuable houses are build on valuable land -- magnifying the difference between rich and poor areas, easier to understand (assessed value is easier than the "land value", which may be arguable), and passes rent onto renters more easily (since they occupy the improvement. In Foldvary's scheme without taxes on these, the land-owner without an improvement pays the same tax as one with land.) I do envy the sprawl-reducing effect of his tax, but it does not make up for these other deficiencies.
27 Feb 2018 (!) Addendum: I link to this post alot, but I have not updated it. First, the addendum above is referring to Henry George's idea of taxing land value alone. Such an idea would give owners an incentive to improve property (to get income off of it in excess of the land tax), but I prefer the "tax wealth" goal to George's "encourage use" goal. Second, I think that property tax is morally justified as a return on citizenship, i.e., "it's our country, so we should benefit from the value of its property." Such a claim does weaken property rights by assuming that ownership does not free one from the property tax, but I think it's reasonable to assume that property value is based on a nation's institutions rather than terra nullis. Finally, I'd return these taxes to all citizens as a "basic income right" appurtenant to citizenship.-->