Principles of an Optimal Tax Policy
The principles of a good tax system point to land value taxation as optimal
June 26, 2016
Fred Foldvary, Ph.D.

Several economists, including Adam Smith and Henry George, as well as policy organizations, have presented some principles of a good (or least worst) tax policy. For example, in 2001 the American Institute of Certified Public Accountants published a report (lead author, Annette Nellen), “Guiding Principles of Good Tax Policy”. The purpose of the report was to provide a guide for policymakers for evaluating the current tax structure and to determine which reforms would improve the systems. We can apply these ten principles to four basic tax bases: income, sales, buildings, and land.

  1. Equity and Fairness. “Horizontal equity” means that similarly situated taxpayers should be taxed similarly. This is difficult to apply on income taxes, since even if, say, all incomes of $50,000 per year are taxed the same, if one family has children and another has a single person, one could argue that the larger family should be taxed less. “Vertical equity” can imply a progressive tax rate that taxes a greater portion of higher income than lower income, but it could also mean that higher incomes pay more than lower incomes, so that a flat or proportional tax satisfies vertical equity.

    For sales taxes, horizontal equity would require a uniform tax rate on all goods, in contrast to today’s U.S. sales taxes that exempt services and some goods. But some locations have a higher cost of living, so that goods are more expensive and sales taxes greater. So for the same goods, some persons would pay more tax than others. As poor people buy a greater amount of taxable goods than the rich, as a portion of their income, sales taxes are regressive and violate vertical equity.

    Taxes on real estate (property in land and buildings) can satisfy horizontal equity when properties of equal value are equally taxed, but in some states, such as California, taxes on real estate are based on the purchase price rather than on the current market value, violating horizontal and vertical equity.

  2. Certainty. The tax rules should clearly specify when the tax is paid, how it is paid, and how the amount is determined. Income taxes provide dates and methods, but the tax amounts are complex and subject to manipulation. There are exemptions, deductions, credits, and tax shelters, as taxpayers seek avoidance. Tax rates and rules frequently change, and some but not all amounts are affected by inflation. Similarly, the amount of sales taxes to be paid depends on how much one spends, the origin of the goods, and the types of goods bought. Property taxes are usually determined by assessed market value, but some states have limitations on increases. The owner has a high degree of certainty about the tax, as he is sent an assessment amount, but it can be lowered by appeal.

  3. Convenience of Payment. Income taxes are made convenient to pay by deducting the funds from wages and financial accounts. Sales taxes are inconvenient when paying cash (counting pennies), and when making a large purchase, having to come up with a big sales tax. Property taxes are made inconvenient when state law, as in California, requires two large payments per year. Property tax could be made convenient by billing monthly and automatically deducting the funds from financial accounts.

  4. Economy. The costs of collecting a tax should be kept to a minimum for both the government and taxpayers. Here the income tax fails big. Compliance costs require record-keeping and filling out complex forms. The taxing agency conducts audits to check on accuracy and evasion. Sales taxes impose a compliance cost to the sellers, especially firms that sell in all the US states, with many counties have different additional rates. The property tax has the best economy in collection: the owner is sent a bill, and pays it.

  5. Simplicity: taxpayers should be able to easily understand the rules and comply with them. Income taxes fail, as many taxpayers hire professional preparers to do their taxes, and firms hire tax accountants. Tax software involves rules difficult to understand. In practice, sales taxes are also complex, as some products are taxed and others not. The property tax wins for simplicity, as it does for economy in collection.

  6. Neutrality: the effect of the tax law on a taxpayer’s decisions as to whether and how to carry out a particular transaction should be kept to a minimum. In other words, the best tax minimizes the excess burden or deadweight loss, caused by a reduction in goods, labor, and investment. Taxes on income, sales, and buildings fail on this criterion. Only the land value tax passes, as it does not affect the land rent. By reducing the purchase price, the tax replaces mortgage interest, and so, after the transition, a tax on land value does not even burden the landowner.

  7. Economic growth and efficiency: the tax system should not reduce the productivity of the economy. Taxes on income, sales, and buildings impede growth by creating a deadweight loss, while a land value tax promotes growth by pushing land to its best use.

  8. Transparency and visibility: taxpayers should know that a tax exists, and how and when it is imposed. Income taxes on business are not visible, as they get hidden in the higher price of goods. Federal excise taxes on goods, including imports, also hide in prices. Taxes on buildings are not transparent, as deductions such as depreciation are hidden from the public. The most transparent and visible tax is on land value, because land cannot hide, and the assessments and taxes are, or should be, a public record.

  9. Minimum tax gap: a tax should be structured to minimize non-compliance. Taxes on income and sales are widely evaded. Building values depend on inspection and disclosure. A tax on land value cannot be evaded.

  10. Appropriate government revenues: the tax system should enable the government to determine how much tax revenue will likely be collected, and when. Most of income taxation is levied on the rich, whose income fluctuates according to the business cycle. Sales taxes also fall during a recession, as people postpone buying consumer durables such as appliances, furniture, and cars. Taxes on buildings are more predictable. Land values do fall during a severe recession, but a land-value tax would reduce the rise and fall of property values, because it would eliminate excessive real estate speculation.

I will leave the evaluation of the tax that best fits the principles to the reader.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., (May 11, 1946 — June 5, 2021) was an economist who wrote weekly editorials for since 1997. Foldvary’s commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary’s areas of research included public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.