A Plan for Systemic Change

Edward J. Dodson

[Comments posted to the Community Development Banking
discussion group, 8 October, 2010]

From time to time, I post my views here on where we are and are headed as a society. And, as I look at a long list of measures the news is not good. We have reason to be fearful that a depression as serious as the 1930s is on its way. The U.S. Congress has bought some time by allowing the public debt to skyrocket to a level unimagined just 15 years ago. Without fundamental tax reform, how will the U.S. government service a $15 trillion debt, pay to keep our military forces in the field around the globe, and meet all of the other demands on government to provide services?

We need an action plan to move on now, and the steps to be action need to be directed at systemic change.

Where taxation is concerned, the perspective of elected officials voting for or against revenue bills has seldom taken actual economic principles into consideration. If that were the case, our state and local governments would not attempt to raise revenue by the taxation of every income-producing activity and every form of asset.

There is a wealth of literature and analysis by economics professors past and present that stresses the need for a reduction (or elimination) of taxation on incomes "earned" from the production of goods or delivery of services, while shifting the revenue base to "unearned" (rent-derived and other inherently passive) income flows and mere financial claims on real assets.

If government is to raise a portion of revenue from the taxation of individual income, the system should be both simple to comply with and progressive. The approach I believe is both economically efficient and equitable is for government to exempt all individual incomes up to some amount (e.g., the national - or, where applicable, the state -- median) should be exempt. Then, eliminate all other exemptions and deductions, social welfare benefits to be handled outside of the tax system. For ranges of income above the exempted amount, a gradually-increased rate of taxation would be applied - the rates and ranges determined during the budgeting process. This simplified graduated tax structure could also be adopted by municipal governments that today apply a flat rate of taxation to wages and salaries.

Municipal, township and county governments rely on property taxation to raise a portion of needed revenue. Historically, school districts have imposed the highest rates of taxation on real estate. However, issues of equity as well as adequacy of property as a revenue base are increasingly a subject of public frustration. The arguments against reliance on revenue from property taxation to fund our public schools are valid. Districts with high property values are able to generate significant revenue with a relatively low rate of taxation, whereas economically distressed districts must receive state and federal support in order to provide comparable levels of educational opportunity to children.

Absent from the debates over how to fund the public school systems is the real impact of property taxation on local and regional economies. There is an optimum amount of revenue that should be raised from property taxation regardless of what the revenue is used for. This optimum revenue equals the aggregate land value of each and every parcel of land within the taxing jurisdiction. Above this aggregate land value the tax is confiscatory and acts as a disincentive to job-creating investment; less than this amount leaves to land owners an imputed (or, when land parcels are leased to tenant users, an actual) rental income stream that is 100% unearned and results in the holding of land off the market for speculative gain. Land values are generated by aggregate demand and are directly related to public investment in infrastructure and amenities. The taxation of property improvement values is, on the other hand, inherently confiscatory and counter-productive. Essentially, improvement owners are penalized for maintaining or improving buildings by what amounts to an annual sales tax on the assessed value of their property improvement.

A related issue is the matter of property assessment, which is almost everywhere influenced by local political pressures and rarely maintained at a uniform percentage of market values. Ideally, if property improvements were exempted from the tax base, the annual tax on land values should be equal to what the land parcel would yield under lease (i.e., its rental value). Even with the existing system the only solution to the assessment inequities is to turn the responsibility over to a state agency run by assessment professionals who meet strict professional credentials.

There has been some discussion in a few state legislatures in favor of legislation that would provide a local option to communities, counties and school districts to adopt a two-rate form of property taxation (as is now permitted in Pennsylvania). This type of bill would authorize local governments and school boards to gradually increase the effective rate of taxation on assessed land values while simultaneously reducing the rate on property improvements. At the end of, say, 5-8 years, property improvements might be fully exempted. Pennsylvania's constitution has extended this option to some but not all taxing bodies, and some have moved - modestly -- in the two-rate direction.

While any shift away from the taxation of the goods or assets we produce and the services we provide one another is sound policy, a comprehensive reform of how government raises its revenue is desperately needed. The measures I have outlined above are neither conservative nor liberal in design; they transcend political orthodoxy and offer a reality-based set of policies that would significantly reduce the probability of another serious recessionary downturn twenty years from now.