The Fallacy of the "Three-Legged Stool" Metaphor
H. William Batt
[Reprinted from State Tax Notes, Vol.35,
No.6, 2 February 2005, pp.377-381]
Tax students, especially at the state level, ply their trade by
invoking one metaphor above all others: the three-legged stool.[1] It
rests on the claim that a sound and successful tax regime for any
government needs to rely on a three tax bases: income, property and
sales. This is repeated so often that it passes today without much
examination.
There seem to be mainly three arguments for this:
- 1. that taxes should be drawn from as wide an array of sources
as possible so as not to overburden any one base or sector.
- 2. that the spread of tax burdens over a number of bases will
ensure greater stability and reliability.
- 3. that reliance upon a wider number of revenue streams
minimizes the downside consequences which all taxes impose on the
economy.
It is even claimed that revenue streams should rely on each such base
in roughly equal proportions, lest structural imbalances will
otherwise eventuate that jeopardize public support of government.
There are of course exceptions. States that have rich mineral wealth
have the luxury of imposing taxes that relieve them of the need to
rely equally on the "big three." So also for states that
have a rich tourist industry or that can rely heavily on gambling
revenue. But a state is open to the charge that its revenue structure
is unbalanced, unfair, or worse unless such special circumstances
warrant.
Such wisdom is found most frequently in the literature of various tax
study commissions periodically constituted over the past thirty years.
Many of the staff directors of these bodies have circulated from state
to state as traveling emissaries, and it is not surprising therefore
that their official reports often bear a striking resemblance to one
another.[2] Typically they address matters such as the extent to which
various taxes conform to the venerable principles of sound tax theory
(discussed further below), their competitiveness with other political
jurisdictions, and the balance of revenue streams.
The Montana Committee study,[3] chosen here simply as a typical
illustration, makes special effort to argue that "elements of a
high quality revenue system are complimentary rather than
contradictory. Taxes should complement each other so they provide a
way to have all economic activity and wealth contribute proportionally
to supporting government services. Taxes should not be just a number
of different methods to generate revenue from the same economic
activity or wealth; thus taxing some segments of society very heavily
and others sparsely."
It goes on to argue that "a high quality state revenue system
reflects the limitations and financial responsibilities that state
government places upon local governments. State policy makers should
be explicitly aware of the costs that state mandates impose on local
governments, and local governments should have the authority to raise
sufficient revenues to meet these obligations. If local governments
lack the revenue bases necessary to provide services mandated by state
government, state policy makers should consider statewide solutions
to avoid extreme inequities. As an example, in some instances, state
government could consider subsidizing local governments to reduce
local tax burdens or increase service levels for governments that lack
enough taxing capacity to meet some state standard of services. This
approach however, should be weighed against the principle of local
autonomy. In which local voters decide which services they want to
receive and raise the money to pay for them."
The Montana study reflects the conventional wisdom that "a high
quality revenue system relies on a diverse and broad based range of
sources. One of the goals of a quality revenue system is economic
neutrality to prevent the distortion of individual and business
behavior. If reliance is divided among numerous sources and their
bases are broad, rates can be made low in order to minimize the impact
on behavior. A broad base itself helps meet the goal of
diversification since it spreads the burden of the tax among more
players than a narrow base does. And the low rates that broad bases
make possible can improve a state's competitive position relative to
other states. When possible, we should try to balance our tax systems
through reliance on the three-legged stool of income, sales, and
property taxes in roughly equal proportions, with excise, business,
gaming, and severance taxes, and user charges playing an important
supplementary role. In any instance, every attempt should be made to
avoid excessive reliance on any single revenue source."
The power with which the three-legged stool analogy has underpinned
tax policy is in fact rather disconcerting, because a close
examination of its premises shows that they are very questionable.
These benchmark measures of a tax regime are scrutinized here in order
to cast doubt on the claims so often made on their behalf.
Taking first the argument that spreading the tax burden over as wide
a base of sources as possible, it is best to begin by noting that
revenue streams can be drawn from only three elements of the economy:
land, labor, and/or capital. Standard textbooks for Economics 101
typically start with recognition of these factors, even if they
usually give insufficient attention to land as a component. Classical
economics, culminating particularly in the tradition of Henry George,
includes in the idea of land any and all components of value not
created by human hands or minds. It therefore means not just
locational sites on the earth's surface that might be bought and sold
as real estate, but other elements of so-called "natural capital"
as well: the electromagnetic spectrum, air, water, fish in the ocean,
mineral wealth, airport time slots, and so on. Those elements have a
market price, and can be - indeed are - often subject to taxation. It
is important to note, however, that taxes on such land are capitalized
in the market value of their worth; they cannot be passed forward or
backward because their supply is essentially inelastic.
This is important, as will be noted below, because imposing such
taxes incurs no excess burden on their use or upon the general
economy. Taxing such bases is totally neutral and completely
efficient. Indeed, it is the failure to tax land as stated that leads
to economic distortions and cause an economy to function at a
sub-optimal level. Land, whatever its form, has a market value only to
the extent that a human presence exists to make use of it, and it
acquires that value due to the accretion of economic rent, the return
on labor and capital, that comes to rest on such factors.
Taxes on labor and capital, in contrast, are always shifted. Studies
of so-called tax incidence seldom trace the flow of tax burdens beyond
the first or second of the shift. Textbooks and research studies will
note that particular burdens - for instance, a tax on the sale of
goods - will be partly borne by the vendor and partly also by the
consumer. The vendor in turn sees that tax incorporated into the price
he pays for the product at the wholesale level; the consumer sees his
burden reflected in the relative cost of living of his tax
jurisdiction - which in turn affects the price of his home and his
wages. The shift in taxes, as economic theory makes clear, are
ultimately converted to rent, and that rent, as capitalized in land
prices, is its final resting place. It is a truism of classical
economics as carried through in the present day tradition of Georgism
that all taxes come out of rent -- an adage that has come to
be abbreviated as ATCOR.
What this insight means is that all taxes not first imposed on
landsites and collected from the rent that rests thereon are instead
passed through the economy from one party to another until they
ultimately come to rest on land. The passing along of tax burdens not
only creates distortions in economic transactions; it also constitutes
an excess burden and an inefficiency that handicaps economic
performance. Taxing capital makes it more expensive and leads to less
saving and investment; taxing labor, in the same way, depresses wages
and discourages enterprise. Contemporary economists and conventional
tax theorists well recognize that taxing labor and capital is
detrimental to economic vitality -- politicians thrive on repeating
this ad nauseum. Currently the Republican party seems best
able to exploit resentment about the negative impact of taxes. But it
is not alone in failing to appreciate the nature of tax shifting. What
all fail to realize is that there are exceptions to the rule that
taxes are destructive: any tax imposed on an inelastic base - that is,
any form of land -- constitutes no distortion or excess burden
whatsoever.
Far from spreading the burden of distribution over a wide array of
tax bases, the ideal tax, then, should be imposed solely on those
factors of production that form an inelastic base, i.e., that
constitute forms of land - whether they be locational sites, natural
resources, the spectrum, time slots, or others as they may arise in
the future. Land, in any of its forms, is totally inelastic. Will
Rogers in his pithy way said it well, "Buy land. They ain't
making any more of the stuff." Mark Twain said it too.
A second claim among advocates of spreading tax burdens over the "big
three" bases (and sometimes more if possible) is that it insures
greater reliability and stability of the revenue streams supportive of
government services. To be sure not all government services require
stable budgets - motor vehicle licensure varies with the state of the
economy as do the needs of social welfare programs and some offices
related to capital investment. But most programs do need to rely on
predictable and stable financial support, particularly education,
health, and public safety. With revenue streams based on formulas that
vacillate from year to year, it becomes difficult to provide for
public needs, and the continual struggle over fiscal designs in the
political arena is frequently costly.
Economic cycles are accepted as a given in both government and
business circles. But there is compelling evidence that such cycles
have their roots in the tendency for elements of the financial
community to speculate in real estate, fostering bubbles in their
market prices that ultimately must be reconciled with the real
demand.[4] Because the market price of landsites is in good part a
function of the settling of rent, the recapture of that rent in the
form of taxation would both stabilize those markets and remove the
cause of those regular cycles. By collecting only a miniscule element
of land rent, and instead collecting revenue from labor and capital,
economic cycles are amplified and exacerbated, to say nothing of their
effect on productivity. Evidence of the stabilizing effect of taxes on
landsites in the form of economic rent collection is shown best by the
fact that those nations and states that rely most heavily on land
taxation are least subject to cyclical tendencies[5] and intermittent
recessions. Japan, which imposes no tax on urban land, has yet to
recover from the crash in hits real estate market almost fifteen years
ago.[6]
The third claim, that reliance upon a wider number of revenue streams
minimizes the downside consequences that all taxes impose, requires an
extensive examination of the various options available. What, first of
all, are those aspects that must be avoided? What are the standards
against which various taxes can and should be measured? These are
typically listed as anywhere from four to even seven depending upon
their description. Mostly commonly are neutrality, efficiency, equity,
administrability, simplicity, stability, sufficiency.[7] Tax theorists
typically measure revenue structures according to any or all of these
criteria:
Tax neutrality refers to the influence (or absence of such) that any
particular design has on economic behavior. Typically taxes are
perceived as a damp on economic activity -- taxing income reduces the
incentive to work, taxing sales discourages retail transactions, and
taxing savings reduces the propensity to save. The more a tax is
perceived to be neutral the less the identifiable distortions it
imposes on the economy. The common assumption of most tax theorists is
that all taxes impose distortions; it's simply a matter of which ones
are least burdensome to economic health. A tax which imposes no
distortions is ideally best.
Tax efficiency is much like tax neutrality, and is the measure of how
much shifting of behavior it imposes, resulting in what is called "excess
burden," or "deadweight loss" on the economy. Tax
economists usually hold that the best taxes are those that are shifted
little if at all. Because the elasticities (a technical word for the
slope of supply and demand curves) of each are very different, a tax
on land values and a tax on improvement values have very contrastive
effects on socio-economic choices. Using a tax base that has little or
zero elasticity is the best way of assuring that taxes are not
shifted. Zero elasticity is another way of saying fixed supply.
The principle of equity is central to any discussion of tax design.
Tax design requires concern with both what is fair and the extent to
which it must sometimes be compromised to satisfy the other principal
criteria. Fairness can be evaluated according to what is termed "horizontal
equity" -- the extent to which those in similar circumstances
will pay similar tax burdens, and "vertical equity" -- how
well those in different classes bear different burdens in the tax
structure. It is this latter perspective that leads to the use of
terms like "proportional," "progressive," and "regressive"
in referring to tax structures. A tax is progressive with respect to
income if the ratio of tax revenue to income rises when moving up the
income scale, proportional if the ratio is constant, and regressive if
the ratio declines. There is an ancillary question of whether taxing
to reach greater equity should employ measures of income or of wealth,
difficult as this is to measure. Such questions of equity are a matter
particularly central when discussing the property tax. This will be
discussed further below.
Administrability refers to the ease with which a tax can be
administered and collected. Taxes which distort the economy are
inefficient but so are taxes that cost lots to administer. This is
measured not only in the direct costs of tax avoidance and accounting
expenses, but in the level of evasion and cheating, and by the cost of
government auditing and policing. When the taxpaying public perceives
that a tax is easily evaded, cumbersome, and unfair, it loses its
legitimacy and calls government itself into question.
This is why the principle of simplicity is important: the more
complex the tax design, the more lawyers and accountants will find
loopholes, encourage the appearance of unfairness, and drive up the
cost of its administration. People know that with simple taxes other
parties are also paying their fair share, and all this enhances the
legitimacy and therefore the compliance of the tax system.
Stability refers to the ability of a tax to produce revenue in the
face of changing economic circumstances. Income and sales taxes, for
example, vary greatly according to phases in the economic cycle; the
property tax, in contrast, is highly stable regardless of the state of
the economy. This is one reason why school administrators have
typically been supportive of using the property tax base rather than
some other tax to support school services.
The certainty of a tax's collection ensures that the number and types
of tax changes be kept to a minimum. Frequent changes in tax rates and
bases interfere with business decisions and the ability to make
long-term financial plans. This concept reinforces the need for
stability because an unstable revenue system is more likely to require
continual adjustments.
In assessing the value of a tax it is also important, of course, to
understand its potential to bring in revenue for the purposes of
government, usually deemed revenue sufficiency. Income, sales and
property taxes, along with corporation taxes to a lesser extent, have
come to be regarded as the workhorses of the American revenue
structure. But, as anti-tax politicians are quick to note, the higher
these taxes are, the more they impose a drag on the economy. This is
why one should ponder whether to consider raising taxes which have
demonstrable distorting effects.
To be sure, all of the "big three" taxes do indeed have
negative consequences. This is because all three are imposed largely
on capital and labor; only a minor component of taxes on property
constitute collection of economic rent. Yet students of the real
property tax readily acknowledge that it has two components: that
imposed on land values and that imposed on improvements. When the
improvements are taxed at a lower rate or when that levy is totally
removed, the tax constitutes a collection of rent alone. Because that
land is part of an inelastic tax base, it is totally neutral,
completely efficient, simple to understand and to collect, a stable
tax base, and easily administrable. This last is particularly
important: in recent years it has become possible in principle to
assess land value by computer algorithms (called computer-assisted
mass appraisal, or CAMA), obviating the need for assessors altogether.
Isobars can be drawn on maps showing land values similar to how
elevations in land topography are shown on geographic maps. A
traditional criticism of conventional property taxation, that
assessment was often arbitrary and subjective, no longer need be a
compelling criticism.
The one criticism often levied against the conventional property tax
is its regressivity. This is in fact belied by the facts. Only two
empirical studies have ever been done on the subject, but both
concluded that the real property tax is mildly progressive.[8] When
the two elements of the property tax are taken separately, it becomes
even clearer why this is so: the land component of real property,
being inelastic, cannot be shifted to tenants, and is borne solely by
the titleholder to the property. When it comes to incidence of
payment, the roughly 35 percent of all American households who rent
and do not own (largely poor people) bear no tax burden whatsoever.
Only the improvement part of the real property tax is in any way
shifted to tenants. Even among the homeowning element of the American
population, studies have shown that a shift of the tax to land values
typically lowers the burden on about two thirds of all households.
This is because landsites on which homes are situated are typically
not in the highest land value neighborhoods, and it is business and
commercial sites - particularly the underused land parcels in those
neighborhoods - that typically bear a larger burden.[9] So that in
fact a tax on land values is really a profound shift in the direction
of progressivity.
If one realizes that houses, just like cars, refrigerators, computers
and other manufactured items, depreciate in value and that only land
increases in market value due to the factors of inflation and rent
accretion, it will become clear that the remedy for onerous real
estate taxes is downtaxing buildings and uptaxing landsites. The
result of doing so will stabilize tax burdens for those who otherwise
resent their payment. In the unusual cases, especially during
transitions, when titleholders of limited income cannot manage such
obligations, taxes can easily be deferred until owners "cash out"
by selling or dying when such debts can be settled. Sales of
appreciated landsites typically provide estates with adequate
wherewithal to both pay any back taxes and give a capital gain too.
The upshot is that a tax on land value alone -- totally neutral,
efficient, certain, progressive, stable, and administrable -- measures
up so well that it looks like the perfect tax! It is even argued that
a land tax is "better than neutral," in that it actually
fosters the kind of economic activity that fosters vibrant
communities.[10] It also has very positive environmental effects
inasmuch as it reverses the centrifugal forces of suburban sprawl
development and stimulates and facilitates investment in urban
cores.[11] Evidence on this matter supports the claim that taxing land
alone is a more appropriate solution to both tax issues and spatial
configuration issues than any other remedy. In the final analysis,
studies show that very few states measure up to the one-third -- one
third -- one-third standard in any case. Political and other factors
aside, there are good reasons for a state's not abiding by such rules.
It is only due to misunderstandings that faith in the big three taxes
constituting the three-legged stool have come to prevail. When these
taxes are measured by the extent to which they conform to the
conventionally accepted principles of sound tax theory, they appear
wanting. By shifting to the collection of economic rent, manifest
mainly in the form of land value taxation, governments will better
succeed not only in overcoming the prevailing resentment against
current taxation policies but provide better financial support for
those services which are the rightful province of public obligation.
REFERENCES
[1] There is no difficulty in
citing such references, in textbooks or online. A quick search of the
web turns up the following as illustrations: A Fiscal Crisis in State
Budgets: Are Taxes in Western States, WRDC Public Policy
Information Brief, No. 2, July, 2003; A Theory and Reality:
Arizona's Tax Structure, by Marshall J. Vest, Eller College of
Business, University of Arizona, n.d.; A Ranking Maine's Business
Climate, by Charles Lawton and Frank O'Hara, Maine Center for Economic
Policy, July, 2004; A Report of the (Ohio) Committee to Study State
and Local Taxes, March, 2003; AComments from the Utah Education
Association on State Tax Policy, n.d.; A [State of] Washington has the
most unfair tax system by Polly Keary, in Real Change, 4/29/04; and A
Look behind the rhetoric of tax reform, by Andy Brack, [South
Carolina] Statehouse Report, Dec. 7, 2003.
[2] There are several studies of the work and value of tax study
commissions, easily available online. One such is by Therese McGuire,
"Toward State Tax Reform: Lessons from State Tax Studies,"
Prepared for the Finance Project, November, 1995, at
www.financeproject.org/toward.html. Some states that have enlisted
such projects are enumerated in that paper, but far from all of them.
[3]A Universal Guiding Principles of Taxation, Prepared for the Tax
Reform Committee, Created by HB461, 2003 Legislative Session, Report
issued August, 2003, and available at
www.discoveringmontana.com/revenue/content/5foryourreference/studycommittees/taxreform/guiding
principlesoftaxation.doc.
[4] See Mason Gaffney, AThe Philosophy of Public Finance, especially,
pp. 188-192, in Fred Harrison (ed.), The Losses of Nations:
Deadweight Politics versus Public Rent Dividends. London: Othila
Press, 1988.
[5] See, for example, David Richards, "Land Markets and Business
Cycles in the UK and Australia," at
www.cooperativeindividualism.org/richards_land_markets_uk_and_au_01.html
; Bryan Kavanagh, "The Recovery Myth, Prosper Australia, 1994;
and John M. Quigley, "Real Estate and Economic Cycles,"
International Real Estate Review, Vol 1, #2 (1999).
[6] See, for example, Mason Gaffney and Richard Noyes, "The
Income Stimulating Effects of the Property Tax," in Fred Harrison
(ed.), The Losses of Nations: Deadweight Politics versus Public
Rent Dividends, London: Othila Press, 1998; and studies of Asian
rim countries' comparative reliance upon land taxation.
[7] Professor Fred Foldvary -- www.progress.org/archive/foldvary.htm
-- has been especially articulate in reviewing the links between land
values, land taxation, and economic cycles.
[8] For a discussion of what students of tax policy regard as the
principles which should guide their design, see, for example, George
Break, "Taxation," Encarta Encyclopedia by Microsoft, 1993; "Principles
of Taxation, in Light of Modern Developments," Washington:
Federal Tax Policy Memo, The Tax Foundation; "Principles of a
High Quality Revenue System," Tax Notes, March 21, 1988; and
David G. Davies, United States Taxes and Tax Policy, (New York:
Cambridge University Press, 1986), pp. 17-19. State studies cited
above also typically list any or all of these criteria. I have seen
accountability, balance, certainty, competitiveness, and complementary
included as well.
[9] See Peter Mieszkowski, "The Property Tax: An Excise or a
Profits Tax," Journal of Public Economics 1 (April 1972):
73-96, cited and discussed extensively by James Heilbrun, "Who
Bears the Burden of the Property Tax?" in Lowell Harriss (ed.),
The Property Tax and Local Finance, Proceedings of the Academy of
Political Science, Vol 35, #1 (1983), pp. 56-71, and Henry J. Aaron,
Who Pays the Property Tax: A New View, Washington: the
Brookings Institution, 1975. See also Harvey S. Rosen, Public Finance,
2nd Edition (Homewood, IL: Irwin Press, 1988), pp. 483-489; Mason
Gaffney, "The Property Tax is a Progressive Tax,"
Proceedings, National Tax Association, 64th Annual Conference, Kansas
City, 1971, pp. 408-426. [Republished in The Congressional Record,
March 16, 1972: E 2675-79. (Cong. Les Aspin.) Resources for the
Future, Inc., The Property Tax is a Progressive T ax, Reprint No. 104,
October, 1972].
[10] For further discussion of this, see the work of the Center for
the Study of Economics, based in Philadelphia - www.urbantools.net.
[11]T. Nicolaus Tideman, "Taxing Land is Better than Neutral:
Land Taxes, Land Speculation, and the Timing of Development," in
Kenneth C. Wenzer (ed.), Land Value Taxation: The Equitable and
Efficient Source of Public Finance. Armonk, NY: M.E. Sharpe, 1999.
H. William Batt, "Stemming Sprawl: The Fiscal Approach," in
Matthew Lindstrom and Hugh Bartling (ed.), Suburban Sprawl:
Culture, Theory, Politics. Lanham Md: Rowman and Littlefield,
2003.
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