Who actually picks up the tax bill?

This discussion paper by Henry Law written in August 1992 is here published with the aim of promoting discussion about the incidence and burden of taxes.

Taxes on the rental value of land have been levied by governments since time immemorial.

The Domesday Book, for example, was a land value tax assessment register, and the feudal system was based on a chain of obligations related to rights over land. Duties were usually in kind — for example, knight service, but towards the end of the Middle Ages, they were commuted for money payments. By the end of the eighteenth century, however, other forms of taxation gradually replaced land value taxes in most parts of Europe.

By this time, economics was well established as an academic discipline, and taxation naturally came under scrutiny. Quesnay, one of the leaders of the French school of economists attached to the court of Louis XV and known as the Physiocrats, argued that “all taxes come from rent” (ATCOR) — in other words, all taxes are ultimately passed backwards to the landowners. This was at a time when taxes in France were of bewildering variety and complexity; if all taxes were ultimately passed on to the landowner, why go to the trouble of levying a variety of taxes, with all the administrative problems which they created? Quesnay therefore suggested that all government revenue could be raised by what he called the “impôt unique”, a tax on the rental value of land, and in 1774, Turgot, a minister in the French government, with the support of King Louis XVI, tried unsuccessfully to initiate Quesnay’s proposed reforms.

The same case was again put forward in 1880 by Henry George in his book Progress and Poverty; it appears that George came to this conclusion independently since he was not aware of the work of the Physiocrats until some years later. George inspired a popular movement which campaigned for the introduction of a tax on the rental value of land (LVT), with the ultimate abolition of all other taxes; this was known as the “Single Tax” programme.

The proposition raises two related questions of considerable general interest:

1 Do all taxes come out of rent? (ATCOR)
2 Could all government revenue be raised by LVT?

What does ATCOR mean?

The ATCOR claim is in the nature of a mental experiment. It is based on the supposition that all taxes were suddenly abolished, whilst the government continued to provide all the services which were paid for from taxation. If the ATCOR thesis were correct, land values overall would rise by the amount of the tax which no longer had to be paid. This is, of course, an impossible supposition, and in this form the argument cannot be effectively developed.

Underlying the ATCOR claim, however, is an assumption of wider concern: that the apparent and actual incidence of a tax are not identical. This process is not necessarily obvious; an analogy is with the alteration of the clocks during “Summer Time”, a device which tricks everyone into rising an hour earlier without their being aware of it. The first stage in developing the argument, therefore, is to see how taxes might be passed on.

Are property taxes passed on to the landowner?

It is not hard to show that, in the long term, all property taxes are passed on to landowners, and that, conversely, reductions in property tax lead to an increase in land values.

Recent examples include:
1 Abolition of the agricultural rate in 1929
2 The ten-year rate-free period in the UK Enterprise Zones
3 Changes in rental value associated with the introduction of the Unified Business Rate in 1990.

There is a wealth of statistical evidence in relation to the link between rents and rates in the Enterprise Zones, notably that collected on behalf of the government by consultants Roger Tym and Partners.

Who pays income tax?

Pay-as-you-earn income tax is usually considered to be paid by workers as a deduction from their wages, but whether this is so depends upon how “wages” are defined. Wages are normally considered to be “gross pay”, but strictly speaking, “wages” are a reward for labour, and it is proper to designate as “wages” only that which is actually available for us to spend, as any employee acknowledges who looks first of all at the “net pay” figure on his pay slip. “Gross pay” can legitimately be regarded as a purely notional amount. On this view, employees’ income tax is passed on to employers.

Is there a fallacy in this argument? Welfare benefit levels effectively set a floor to wages since no-one would work for less than they can receive if unemployed. Assuming that, for the sake of argument, the total value of the benefit is £80 per week, to leave the worker with the same amount in take-home pay would cost an employer a gross figure of more than £103. (this figure includes the “employer’s” and “employee’s” national insurance contributions)

This observation is not original. Adam Smith made the same point in Wealth of Nations.

“While the demand for labour and the price of provisions, therefore, remain the same, a direct tax upon the wages of labour can have no other effect than to raise them somewhat higher than the tax. Let us suppose that in a particular place the demand for labour and the price of provisions were such as to render ten shillings a week the ordinary wages of labour, and that a tax of one-fifth, or four shillings in the pound, was imposed upon wages. If the demand for labour and the price of labour remained the same, it would still be necessary that the labourer should in that place earn such a subsistence as could be bought only for ten shillings per week, or that after paying the tax he should have ten shillings a week free wages. But in order to leave him such free wages after paying such a tax, the price of labour must rise, not to twelve shillings a week, but to twelve and sixpence…

“A direct tax upon the wages of labour, therefore, though the labourer might perhaps pay it out of his hand, could not properly be said to be even advanced by him;…

“In all such cases, not only the tax, but something more than the tax would in reality be advanced by the person who immediately employed him…

The arguments set out above are not decisive and hinge on the definition of “wages”. If wages are defined as reward for labour, then wages are not gross pay, nor even net pay, but the actual goods and services which can be purchased out of a pay packet. The assumption here is that workers are concerned primarily with what they can purchase from the proceeds of their labour.

This is not an unreasonable premise, but it would follow that not only are direct taxes such as income tax passed on to the employer, but “indirect taxes” also, as will be considered later.

An alternative view is to suggest that the disposable income of employees must be unaffected by wage-related taxes, and must be determined by market forces. Wages are set at the bottom end of the scale by the cost of buying workers out of the dole queue, and wages all the way up the scale follow suit.

The key question is what would happen if all nominally labour-related taxes were transferred to employers in the shape of a payroll tax? Would take-home pay rise or stay the same? Because employers could not allow their total labour costs to rise, they would be forced to negotiate with their employees, who would be obliged to accept the previous take-home pay.

Conversely, we know that, historically, workers have used a variety of measures to resist any erosion of the purchasing power of their wages, whether due to taxation or inflation, and it seems possible that the tax element has gradually been passed on to employers by this mechanism.

A similar process may be at work at high levels of pay, where employees are often reluctant to accept the extra responsibility of promotion if the increased pay brings them into a higher tax band. A further disincentive of the same kind affects employees with children receiving higher education, whose grants are means-tested according to their parents’ incomes.

To conclude therefore: a good case can be made out for the claim that wages on labour are passed on to employers, but it is difficult to demonstrate directly. A more important issue actually relates to the role of these taxes in maintaining unemployment, and this must call into question the entire structure of the tax and benefits system, which has a profound influence on the minimum price of labour. It is obviously a very serious matter, but is tangential to the question under discussion.

Does the social wage count as “wages”?

Here again, the answer depends on the definition of wages. If wages are “reward for labour”, then the social wage is not a true wage, since there is no direct connection between individual labour and reward. Most government spending consists of transfer or infrastructure payments, and much of this goes to sustain land values.

Sales taxes

Are sales taxes are passed on to employers? There is no doubt that welfare benefits include an element to cover value added tax paid by recipients. The same must apply to wages, if what really matters are the actual goods and services which can be purchased. Thus, similar considerations apply to sales taxes as to wage-related taxes, and it could be argued that in the long run, the bill for VAT is now being shouldered by employers.

The case of British Steel

Around 1981, an accountant (Emil Woolfe) analyzed the losses made by British Steel, using the argument that the true incidence of income tax and employers’ and employees’ National Insurance contributions (NICS) fell on the employer and operates as a payroll tax. Woolfe considered the value added by the enterprise and the ways in which it was divided: part going to the workers, part to capital in the form of interest payments and part to the government, under the title “employees” income tax, etc. It could be objected that there is this analysis involves some sleight of hand, but there is no doubt that the tax paid by the employees must somehow come from the wealth created by the activities of the enterprise for which they work.

Woolfe concluded that the company losses were considerably exceeded by the contribution made to the exchequer in the income tax and national insurance contributions paid by employees’ and employer. On this basis, the enterprise was economically viable, since it was at least capable of paying wages to its staff and interest on the capital employed. On the other hand, it could be objected that if the business could not cover its employees’ tax liabilities, it was parasitic on the economy as a whole.

However, the ultimate test of economic viability is whether an enterprise is capable of yielding a surplus (rent) over and above the return to labour (net wages) and capital; so long as this surplus is greater than the market rental value of the land occupied by the enterprise, the business is economically viable.

Businesses operating on sites of low land value may well be paying more in taxes, under the heading of PAYE income tax and National Insurance, than they are receiving in benefits from public services. This could account for some of the difficulties at present experienced by the coal and steel industries.

Are taxes on employers passed on to landowners?

Even if were conclusively shown that taxes on labour and taxes on goods and services were passed on to employers, the final link in the chain must still be demonstrated, by which the employers pass the tax on to landowners.

If tax reductions result in a reduction in the price of labour, this ought to improve the profitability of business, and if businesses are more profitable, they are capable of bearing higher levels of rent. A pointer in this direction is the exceptionally high value of land in tax havens such as Jersey. In practice, matters are not as simple. Most businesses already occupying premises are locked into long-term leases with little opportunity of changing the terms or getting out. And although business tenants test the market when seeking premises, their knowledge is limited. Nevertheless, as is readily observed during boom periods, when business profitability is increasing, rents increase also. Although it seems probable that tax cuts would ultimately be absorbed in higher rents, the process is both prolonged and diffused, making it impossible to show that a particular amount of tax cuts had led to a corresponding rise in rental values.

ATCOR – An alternative analysis.

As we have seen, a step-by-step analysis provides only limited evidence to support the hypothesis that all taxes come out of rent. It could not be regarded as conclusive proof.

An alternative approach is to go back to first principles and consider a theoretical state of affairs based on the analysis put forward by Ricardo. This postulates six sites A to F, whose productivities range from 10 to 60 units; these figures assume equal inputs of labour and capital. Such situations rarely occur in practice, but examples such as newspaper sales pitches and sites used by street musicians come close to the ideal model. Rent is defined as the surplus over the margin, the marginal site being the least productive site in use. (site F) The margin is the least that anyone is prepared to accept. It is not an absolute, but a street musician, for instance, might not be prepared to work for less than £5 an hour. In the UK, labour margins are determined by factors such as the welfare safety net.

What if a tax is levied nominally on labour and capital? Its effect is to force site F out of use, because it is no longer possible to earn a acceptable livelihood by working there. The marginal site then becomes site E, whose productivity is 20. The rental values of all of the other sites are reduced by 10 units, and it will be observed that the total rental values have fallen by the amount of the tax collected. Thus it can be said that the burden of the rent has fallen on the landowner. Total production is also reduced by the loss of site F.

A more realistic description of the economy is instructive. Present taxes are partially a tax on rent because income from rent is not distinguished from income from other sources. But taxes levied specifically on labour and capital can still be said to come out of rent because of the effect of these taxes at the margin. Again, site F is forced out of use.

If taxes are reduced, total rental values rise because the margin shifts. Since rents are the surplus over the marginal site, a shift in the margin affects all rents on all sites.

What is the effect of levying tax only on the rental value of land (LVT)? The marginal site F remains in use, just as it would in the absence of tax. A shift from present taxes to LVT results in higher pre-tax rentals because rentals are established in relation to site F instead of site E. This is a paradoxical result, because normal considerations of supply and demand would predict that a tax would lead to reduced demand and a fall in price. Clearly, analysis of the land market cannot be achieved by the use of supply and demand curves. Thus LVT is an exception to the rule that taxes reduce demand for the entity taxed, the price falling in consequence – but this is due to the effect of reducing the other taxes.

In practice, a change to LVT would introduce forces tending to drive land values down; vacant land would be brought onto the market and landlords would be very careful not to push tenants to the point of leaving, because they would then be saddled with the tax bill.

The diagrams provide convincing evidence for the proposition that all taxes come out of rent. But how valid a model are they? They describe a simple and highly artificial state of affairs. When translated into the real economy, the story they tell can be regarded as no more than a tendency. An important discrepancy will arise from time lag.

Nevertheless, the model seems to have important characteristics which mirror the real economy. The step diagrams appear to shed light on the incidence of all taxes. If it can be criticised, it would be on the grounds that the post-tax return to wages and capital actually varies according to location. But in fact, real wages (actual goods and services which can be purchased) tend to even-out, the difference (London weighting, etc) being absorbed in house prices (rent).

If all taxes did not come out of rent, it would follow that net wages would be higher in areas where land values were higher, which is certainly not the case in London, where land values vary by a factor of at least five between central and suburban commercial locations. The difference in pay between central and suburban areas is accounted for by travelling costs and the value people put on the time and trouble involved in the journey to work. And experience shows that wages tend to even up, whilst rents tend to absorb differences.

Further evidence of the validity of the model relates to way in which it describes what happens at the margin. The diagrams show that all taxes other than LVT will result in marginal sites being put out of use. The government has been forced to compensate for the disadvantage of locations such as Northern Ireland with a complex system of subsidies, while it continues to take resources out of the province through the tax system which differs not at all from that in the prosperous South-East. It may well be that much of the manufacturing industry which has disappeared in the past twenty years was sub-marginalised by the tax system. The more remote parts of the UK (anywhere north of the Trent and west of the Severn) suffer from geographical disadvantage; transport and telecommunications are important costs. Stuttgart is closer to markets and suppliers than Sunderland. Perhaps British industry has been over-taxed?

  If the step diagram is right, LVT would not lead to increases in wages. Its initial effect would be to bring vacant sites into use and extend the margin. This would soak up the pool of unemployed labour. The diagrams also indicate that with a change to LVT, the pre-tax rent proportion of GNP will increase because of the marginal sites which would be brought into use. 

And on the basis of the diagrams, if all government spending is at the expense of rent, with a tax rate of 100% LVT, the government would have more income than it could spend, because existing rents would also be captured. It would be necessary to introduce something like the national dividend – Basic Income. With Basic Income, people might be prepared to accept very low returns on their labour since they would still be better off than if they did nothing. This would further extend the margin, thereby increasing rents. See Beyond the Welfare State by Brittan and Webb for a discussion of this issue.

Can all government expenditure be financed by a tax on the rental value of land?

A tax system is essentially a means by which those engaged in commercial activities can support non-commercial public services. From the preceding discussion, it can be concluded that the best case for the argument that all taxes come from rent is that derived from the theoretical model. Nevertheless, this does not constitute proof.

The statistical argument

This approach to the question simply measures present land values and calculates the rate of tax required to yield any given sum. The problem here is that even if it is not true that “all taxes come from rent”, there is obviously a link between rental values and levels of taxation and the abolition of the present taxes would bring about an increase in land values.

A recent study (Costing the Earth) has been calculated that, in 1985, the rental value of all the land in Britain was 22% of national income.

At a detailed local level, evidence of land values as a base for taxation comes from the Whitstable surveys conducted in 1964 and 1973. The latter survey revealed that the rental value of all the sites was £3,700,000, compared to the £2,700,000 value of sites and buildings as measured by the Inland Revenue values a year previously. Because of the increase in land values between 1972 and 1973, these results were not directly comparable, but the important difference was the inclusion in the tax base of development sites; the survey revealed a large amount of vacant but developable land in the town centre not assessed under the rating system. With a straight change to a site value rating system, because of the expansion of the tax base, both commercial ratepayers and residents would have paid considerably less; the average commercial bill would have been about 35% and the average residential bill about 90% of what they were paying at the time.

The jam pot argument

A completely different approach to the question avoids the necessity of collecting data and making calculations. Any tax system can be considered simply as a method of allocating the tax load amongst taxpayers; replacement of existing taxes by LVT simply replaces one formula for determining tax liability by another. The assumption here is that all taxes come out of the same pot – the economy as a whole.

This argument was put forward in Georgist Journal 60, (Summer 1988) by Lawrence Clark of Medfield, Mass. The idea is worth further exploration. If all government revenue comes from the economy as a whole, in principle, all government revenue might be collected by a single tax imposed on any arbitrarily selected entity; it could be a flat rate poll tax, an income tax, Value Added Tax, a window tax, a clock tax, or a tree tax. Various practical problems have arisen with all of these. In the case of the flat rate poll tax, not all taxpayers had the wherewithal to pay. The window tax led to bricked-up windows, the clock tax ruined the clock and watch industry, and a tree tax encouraged people to cut down their trees. VAT and income tax do not have these dramatic consequences, but their effect might be compared to a low-grade infection or friction in the economy: unless they are set at very low rates, both taxes influence people’s actions in various ways and depress economic activity overall.

Thus LVT could be regarded as just another formula for distributing the tax burden. In the case of a LVT, the effect would be to encourage people to reduce their land holdings to the minimum which they required. Since land does not vanish into thin air, the imposition of the tax would simply make it more readily available to anyone who wished to use it.

There is a natural limit on the amount of revenue which can be raised by LVT, since it is not possible to levy the tax at more than 100% of the rental value of a site. Any attempt to do so will drive the land out of productive use. But this is true of any other method of taxation; if the taxes are so high that no rental surplus remains, the land will become sub-marginal.

Henry Law August 1992