Principles of taxation and how our rates system stacks up

The three most important principles of how to tax well

Principles of taxation

When determining how to raise revenue, governments should try to adhere to sound principles of taxation, rather than just doing whatever looks good or sticking with the status quo. Below are what we view as the three most important principles of how to tax well. 

1) Equity

Where possible, taxes should be proportional to ability to pay, in order to promote equity. This does not mean everyone pays the same percentage; we have progressive income taxes because a rich person is much more able to pay 35% of their income than someone on minimum wage. Generally speaking, whenever the government is raising revenue it should try to minimise the burden on those who are struggling.

2) Efficiency

Taxes should promote market efficiency, either by having minimal impact on markets or by promoting socially good outcomes. For example, the cigarette tax reduces the number of smokers with the goal of saving lives. Many taxes are not efficient, such as property taxes which stifle development, and income taxes, which reduce the incentive to work. 

3) Simplicity

Taxes should be simple and straightforward, with as few special cases and loopholes as possible. Ratepayers should be able to understand how their rates are calculated. They should also be as easy as possible to administer i.e. difficult to evade and low in bureaucratic overhead. Every dollar lost to compliance costs or tax evasion is a dollar wasted.

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Rates in New Zealand

Although we don’t call them that, rates in local government are just taxes and the ideal rates system would adhere to all three of these principles. Here we divide rates into four types, and summarise how they do according to each principle.

As you can see, Land Value Rates do well on Equity, Efficiency and Simplicity and so are an ideal candidate for a rates system in New Zealand. For more information about these different types of rates and how we rate them, keep reading.

Uniform & Per-Unit Charges

These rates are a flat fee either per property or per unit within that property. 

Equity: They totally fail on Equity, since you pay the same whether you have a $1M house or a $4M house. If you’re low income, the proportion of your income you spend on these charges is far greater than that for a high income person.

Efficiency: It varies depending on whether e.g. an apartment block is seen as one single property with many units, or instead as many individual properties. Overall, these charges can range from neutral to very bad for development.  In many cases, the stated reason for these charges are to pay for things like water usage and sewerage, but since the amount you pay is the same regardless how much you use, there’s no incentive for people to use water responsibly. Furthermore, these costs are often related not to the number of units, but the length of pipes to lay and maintain. So benefits to councils from denser properties (lower infrastructure costs) are not properly accounted for. 

Simplicity: These types of rates can be quite simple: if all you do is charge every property a flat fee, you don’t even need to have them valued. However that would be horrendously regressive (essentially a poll tax) and in reality there can be other complications, such as water rates that differ depending on access to the water supply.

Differential and Targeted Rates

These rates don’t apply to all properties, but only those under certain conditions. For example, commercial properties often pay differential rates that are significantly higher than residential, and properties that have access to certain amenities or services can pay targeted rates.

Equity: It really depends on the rate. The commercial differential can be justified by its reduction of the burden on homeowners, but it also means higher costs for businesses which can translate into higher prices. Hypothetically you could get something akin to progressive taxation by charging higher rates on wealthy neighbourhoods, but this is not done in practice and would run into other problems.

Efficiency: In general, not efficient (unless based on Land Value), as it distorts market outcomes by raising the costs of development on some areas or types of properties by more than others. For example, the Greater Wellington Regional Council puts a rates burden on commercial properties in central Wellington that is almost four times higher than those in the outer suburbs due to its targeted rate for transport. This has the effect of pushing development out of the CBD. 

Simplicity: These rates really fall down on simplicity, as they require many different categories and arbitrary distinctions to be drawn. Targeted rates based on geography need to have borders, and that means a house on one side of the border paying more than a house on the other side, even if the houses are identical and right next to each other. Large amounts of money and time need to be spent by councils deciding the size and coverage of each targeted rate, in a process that is opaque to ratepayers.

General Rates (Capital Value)

Capital Value Rates are levied on the total value of a property.

Equity: These rates do decently on equity as the owners of more valuable property will always have a bigger rates bill, even though it’s essentially a flat tax. 

Efficiency: Capital Value Rates are bad for efficiency as they are a disincentive to development and therefore reduce housing supply. This is bad for housing affordability as it means fewer houses are built. 

Simplicity: Pretty simple, as you’re just setting a single rate. In terms of the valuations, there can be instances where Capital Value data is either more or less reliable than Land Value data, but in general valuators should be able to accurately assess either.

General Rates (Land Value)

Land Value Rates are levied on just the land value of a property, so the rates bill doesn’t change regardless of improvements.

Equity: These rates are the most equitable of the bunch, as they are generally more equitable than Capital Value Rates. However this is not a law of nature, but a feature of our cities - we can certainly imagine a world where the reverse is true and it should be looked at on a case-by-case basis. Broadly speaking, Land Value Rates tend to be more equitable because rich suburbs often have very high land values, and lower income people disproportionately live in dense housing i.e. apartments. There’s also a body of evidence and economic theory to suggest that landlords are less able to pass Land Value Rates on to renters which would certainly be a win for equity, but we’ll expand on that in a later post.

Efficiency: Peak efficiency. These rates are the same no matter what gets built, so developers don’t face a barrier to making productive use of the land. If anything, Land Value Rates actually contribute to development by making it less profitable to land bank, thereby forcing the owners of empty lots to either build something or sell to someone who will. Land Value Rates also helps councils recoup the cost of infrastructure projects such as Let’s Get Wellington Moving.

Simplicity: Similar to Capital Value Rates, easy to administer and getting accurate valuations is very doable.