Land value tax - the best of all possible taxes

What gives a piece of land its value? Why is a 500 square-foot spot in London worth more than 500 acres of land in Angus? The answer is obviously its location.

The value of a bit of land is not in the land itself, but in the location of that land. And what gives the location value is what is going on around it. Think good transport links, good schools (a house in the UK by a good school is worth anything from 5 to 20% more than one near a bad school), hospitals and the infrastructure to provide jobs.

This brings us to the key question: who facilitates the provision of all these services? The answer to that, of course, is the taxpayer, via the state. But if it is the state that gives land some of its value (clearly there is also value in non-state provided things, such as beauty and mineral rights), why is it that all of that value generally accrues to individual landowners, rather than to the state?

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That, in a nutshell, is the argument for land or location value tax (LVT).

An LVT is levied not on the value of a property but on the value of the land that property sits on. After all, it is not the actual bricks and mortar that make a flat in, for example, London's One Hyde Park worth £6m-plus, it is the land on which it sits. So the LVT is just an attempt to collect tax on a regular basis on what economists used to call the unearned betterment' part of the value of a property the part that is nothing to do with the actions of the owner and everything to do with the actions of the community.

In theory, it is not just an excellent tax, but the best of all possible taxes.

Once the initial valuations have been done, it is phenomenally easy to collect, and all but impossible to avoid. It also discourages speculation and stops in its tracks the endless cycle of investment in land and property purely to rent it out. It promises no more property boom and bust. But, as it is not collected on any improvements made to land or to buildings on land, it does not discourage productive activity. Instead, it encourages people to bring idle land into use, to improve land they own and to be as productive as possible (when you have a pure LVT, earned income isn't taxed at all). The end result is, in theory at least, good for society, good for the state, good for equality and good for growth.

Most people these days have never heard of the idea of an LVT, but the idea that it is a perfect tax has been around for centuries. Adam Smith noted its efficiency; David Ricardo was all for it; and it was hugely promoted by the US newspaper editor Henry George in the US in the late 19th century. George believed that LVT should be a single tax - its efficiency and productivity-enhancing effects would be such that all other taxes could and should be done away with.

It was a hobbyhorse of Winston Churchill's. He was convinced that "land differs from all other sorts of property" and put the LVT case like this: "Unearned increments in land are not the only form of unearned or undeserved profit, but they are the principal form of unearned increment, and they are derived from processes which are not merely not beneficial, but positively detrimental to the general public."

Churchill also offered a fabulous example of unearned betterment. A parish church started to give out free food to poor people living in a particular area. Demand to live in the area rose. The main beneficiaries of this surge in community spending, were the local landowners - their rents and hence the value of their land rose in response to the free bread. The effect on the poor was entirely neutral: they paid less for their food but more for their shelter.

Churchill was not alone in being a fan in 20th-century Britain. An LVT (then called a site value tax or SVT) was suggested in the 1910 budget. That failed to work out. But the idea did not go away.

In the mid-1960s an article in the Statist magazine explained to London readers that the tax would "reverse the trend of soaring land values and reduce housing costs". The writer was sure that support for an SVT was such that "a concerted effort at this stage should carry the day". It did not. But the idea has remained. Today there are variants of LVTs in a number of countries and progressive taxes on residential property act in much the same way.

In Denmark, citizens pay 1% of the value of their property to the state for the first DKK3.04m (£343,000) of its value, and 3% for anything over that. There is also a municipal tax based on land values.

In Singapore, those living in expensive properties pay 15% a year and will soon pay 16%. Most US states have a property tax of one kind or another (the highest come in close to 2%) and Pennsylvania even has something close to a real LVT in that many of its cities collect tax at a higher rate on buildings than they do on the land itself. There is also a lot of lobbying by supporters of LVT for more countries to do the same. The OECD describes it as the most efficient type of tax possible on the basis that it is easy to collect and does little to distort real economic activity.

In the UK, Vince Cable, the business secretary, is also clearly a fan. He talked about it in his pre-government days and mentioned it at his last party conference. But his support of the so-called mansion tax in the UK really makes the point. The tax would be levied on all residential properties in the UK with a market value of more than £2m. This is not actually a mansion tax: it catches small houses in London and ignores vast ones elsewhere. Nor is it really a wealth tax. Instead, it is mostly a location tax: it makes people pay for the privilege of owning property in desirable areas. A recent report by the UK think-tank IFS also called for a "housing services tax" to be "levied as a proportion of up-to-date values" of properties with no cap. So, an LVT in effect.

Then there is Scotland. Whatever happens in the independence referendum next year, Scottish landowners are likely to find themselves facing threats of a new tax. I know this because the SNP has announced changes to stamp duty the UK property transactions tax. The rates have not yet been confirmed but the key is this: it is no longer to be called stamp duty. It is to be called the land and buildings transaction tax. Note the separation of land and buildings. The LVT appears to have friends in the north.

So here are the crucial questions: is an LVT worth having and does it work? That is pretty hard to say. Look at Denmark. Fans of the LVT will be irritated to note that it has suffered something of a property price crash over the past few years, even as its neighbour Sweden which slashed its own property taxes to almost nothing (a maximum of SEK6,000, or £585) and abolished wealth taxes in 2000 has not (yet). There has been a lot of speculation in the Danish market. The Danes love buy-to-let investments in the same way as the British do, and in the run-up to the crash their banks loved to compete to lend cheap money. Then there is the US, where an out-of-control property bubble, from which as far as I can see Pennsylvania was never immune, kicked off one of the worst financial crashes in history. So much for that.

Still, just because countries with progressive-looking property taxes have crashes does not necessarily mean that the tax could not work. In the vast majority of cases in which it has been applied, it has not been high enough relative to other taxes to make a difference. You might pay pretty big property taxes in Denmark (by European standards) but you also pay an awful lot of tax on everything else too. Cars, for example. If you buy a Renault Scenic in the UK it will cost £20,975. Buy it in Denmark and it will be £34,400. A pretty basic BMW 5 series costs £29,830 in the UK, and £63,800 in Denmark. And a basic Range Rover is £70,000 in the UK, and £250,000 if you want to pick it up in Copenhagen. Oh, and the top income tax rate is not only more than 50% but it kicks in at a mere DKK389,900 (£44,000). The LVT only really works (or so the theorists say) if it is the only tax in town. And it never is.

That means that people still think of houses and their affordability in terms of the price and availability of credit relative to the rent available from the property not in terms of taxes. In a low interest rate environment bubbles will be bubbles regardless of the tax regime. We may never find out if an LVT works or not because Western governments will probably never properly implement one. But homeowners may end up paying it in some form or another anyway. The absolute level of the tax is unlikely ever to be very high in the West. Governments are scared of upsetting homeowning electorates by introducing taxes that push prices down, and they also know that permanently lower house prices would be a nightmare for the overexposed banks of the West.

However, as Brian Reading, of economic consultancy Lombard Street Research, points out, when governments cannot squeeze quite enough money out of their existing taxes, they tend to introduce new ones. The recent signs of improvement across the West notwithstanding, it is obvious that as populations age and growth stays low (there is only so long you can borrow growth from the future with ultra-low interest rates) tax revenues will disappoint. That means new taxes.

New taxes mean wealth taxes for the simple reason that there is not much else left to tax. And in the main, wealth taxes mean property taxes. That is partly because you can collect them, and partly because you can back up the case for them with a huge pile of academic research. We will get more of them. But unfortunately we will also get them for all the wrong reasons not because our governments want to try a new method of encouraging productivity, but because they have lost control of their finances.

This article was first published in the Financial Times