Ad valorem tax

Taxation
Types of Tax
Ad valorem tax ·  Consumption tax Corporate tax ·  Excise Gift tax ·  Income tax Inheritance tax ·  Land value tax Luxury tax ·  Poll tax Property tax ·  Sales tax Tariff ·  Value added tax
Tax incidence
Flat tax ·  Progressive tax Regressive tax ·  Tax haven Tax rate

An ad valorem tax (Latin for according to value) is a tax based on the value of real estate or personal property.

Charge of “ad valorem tax” are levied as a percentage of value of the item it is imposed on, and not on the item's quantity, size, weight, or other such factor.

An “ad valorem tax” may be assessed when property is purchased, in the form of a sales tax or value added tax (VAT), or it may be levied later on a set basis, such as once a year or once a quarter. Ad valorem taxes can also be assessed on estates, imports, and in other circumstances where property of value changes hands, e.g. inheritance tax, surrendering citizenships, etc.

Main types of “Ad Valorem Taxes”

Sales tax

A sales tax is a consumption tax charged at the point of purchase for certain goods and services. The tax is usually set as a percentage by the government charging the tax. There is usually a list of exemptions. The tax can be included in the price (tax-inclusive) or added at the point of sale (tax-exclusive).

Most sales taxes are collected by the seller, who pays the tax over to the government which charges the tax. The economic burden of the tax usually falls on the purchaser, but in some circumstances may fall on the seller. Sales taxes are commonly charged on sales of goods, but many sales taxes are also charged on sales of services. Ideally, a sales tax is fair, has a high compliance rate, is difficult to avoid, is charged exactly once on any one item, and is simple to calculate and simple to collect. A conventional or retail sales tax attempts to achieve this by charging the tax only on the final end user, unlike a gross receipts tax levied on the intermediate business who purchases materials for production or ordinary operating expenses prior to delivering a service or product to the marketplace. This prevents so-called tax "cascading" or "pyramiding," in which an item is taxed more than once as it makes its way from production to final retail sale.

There are several types of sales taxes:

• (1) Seller or Vendor Taxes,

• (2) Consumer Excise Taxes,

• (3) Retail Transaction Taxes

Application of the Sales and Excise tax

United States of America

Ad valorem duties are important to those importing goods into the United States of America because the amount of duty owed is often based on the value of the imported commodity. Ad valorem taxes (mainly real property tax and sales taxes) are a major source of revenues for state and municipal governments, especially in jurisdictions that do not employ a personal income tax.

• (4) Value-Added Taxes.

Value-added tax ( VAT )

The VAT was invented by a French economist in 1954. Maurice Lauré, joint director of the French tax authority, the Direction générale des impôts, as taxe sur la valeur ajoutée (TVA in French) was first to introduce VAT with effect from 10 April 1954 for large businesses, and extended over time to all business sectors. In France, it is the most important source of state finance, accounting for approximately 45% of state revenues.

Application of a Value-Added tax in the World

United Kingdom

The third largest source of government revenues is value-added tax (VAT), charged at the standard rate of 15% on supplies of goods and services. It is therefore a tax on consumer expenditure. Certain goods and services are exempt from VAT, and others are subject to VAT at a lower rate of 5% (the reduced rate) or 0% ("zero-rated").

Canada

The Canadian Goods and Services Tax (GST) is a multi-level value-added tax introduced in Canada on January 1, 1991, by Prime Minister Brian Mulroney and finance minister Michael Wilson. The GST replaced a hidden 13.5% Manufacturers' Sales Tax (MST) because it hurt the manufacturing sector's ability to export. The introduction of the GST was very controversial. As of January 1, 2008, the GST currently stands at 5%.

Australia

The Goods and Services Tax is a value-added tax of 10% on most goods and services sold in Australia.

It was introduced by the Howard Government on 1 July 2000, replacing the previous federal wholesale sales tax system and designed to phase out the various state and territory taxes such as banking taxes, stamp duty and land value tax.

Europe

A common VAT system is compulsory for member states of the European Union. The EU VAT system is imposed by a series of European Union directives, the most important of which is the Sixth VAT Directive (Directive 77/388/EC). Nevertheless, some member states have negotiated variable rates (Madeira in Portugal) or VAT exemption for regions or territories. The regions below fall out of the scope of EU:

• Åland Islands (Finland)
• Heligoland island, Büsingen territory (Germany)
• Guadeloupe, Martinique, French Guiana, Réunion (France)
• Mount Athos (Greece)
• Ceuta, Melilla, The Canary Islands (Spain)
• Livigno, Campione d'Italia, Lake Lugano (Italy)
• Gibraltar, The Channel Islands (United Kingdom)

Under the EU system of VAT, where a person carrying on an economic activity supplies goods and services to another person, and the value of the supplies passes financial limits, the supplier is required to register with the local taxation authorities and charge its customers, and account to the local taxation authority for VAT (although the price may be inclusive of VAT, so VAT is included as part of the agreed price, or exclusive of VAT, so VAT is payable in addition to the agreed price).

VAT that is charged by a business and paid by its customers is known as output VAT (that is, VAT on its output supplies). VAT that is paid by a business to other businesses on the supplies that it receives is known as input VAT (that is, VAT on its input supplies). A business is generally able to recover input VAT to the extent that the input VAT is attributable to (that is, used to make) its taxable outputs. Input VAT is recovered by setting it against the output VAT for which the business is required to account to the government, or, if there is an excess, by claiming a repayment from the government.

Different rates of VAT apply in different EU member states. The minimum standard rate of VAT throughout the EU is 15%, although reduced rates of VAT, as low as 5%, are applied in various states on various sorts of supply (for example, domestic fuel and power in the UK). The maximum rate in the EU is 25%.

A value-added tax (VAT), or goods and services tax (GST), is tax on exchanges. It is levied on the added value that results from each exchange. It differs from a sales tax because a sales tax is levied on the total value of the exchange. For this reason, a VAT is neutral with respect to the number of passages that there are between the producer and the final consumer. A VAT is an indirect tax, in that the tax is collected from someone other than the person who actually bears the cost of the tax (namely the seller rather than the consumer). To avoid double taxation on final consumption, exports (which by definition are consumed abroad) are usually not subject to VAT and VAT charged under such circumstances is usually refundable.

History of VAT adverse effect in EU

What has VAT achieved in EU is, however, an important issue here:

• VAT expands the cost of government. Countries with VATs have a much heavier total tax burden than those without VATs. Before the creation of VATs, the burden of taxation in Europe was not that much larger than it was in the United States. However, since the late 1960s, when countries in Europe began to adopt VATs, Europe’s aggregate tax burden has increased by about 50 percent while the U.S. tax burden has remained relatively constant ( Bickley, 2005.)

• Inadvertently increases income tax rates. One of the main arguments for the VAT is that it is a less destructive way to raise revenue. This is theoretically true, but irrelevant. In the real world, the VAT has been used as an excuse to increase income taxes as a way to maintain “distributional neutrality.” Indeed, income taxes in Europe today are higher than they were when VATs were implemented.

• Slows economic growth and destroy jobs. A VAT undermines economic growth for two reasons. First, it reduces incentives to engage in productive behavior by driving a larger wedge between pre-tax income and post-tax consumption. Second, it facilitates larger government and the concomitant transfer of resources from the productive sector of the economy to the public sector, diminishing economic efficiency ( Engen, 1992.)

Conclusion on VAT theoretical and practical effects

We have said above that value-added tax (VAT), or goods and services tax (GST), is tax on exchanges. It is levied on the added value that results from each exchange. It differs from a sales tax because a sales tax is levied on the total value of the exchange. For this reason, a VAT is neutral with respect to the number of passages that there are between the producer and the final consumer. A VAT is an indirect tax, in that the tax is collected from someone other than the person who actually bears the cost of the tax (namely the seller rather than the consumer). To avoid double taxation on final consumption, exports (which by definition are consumed abroad) are usually not subject to VAT and VAT charged under such circumstances is usually refundable.

On the other side, the VAT, as a consumption tax, taxes business profit and total employee wages directly. Collection of employee wage taxes, in the case of Income Tax, which is not an issue here; we just use it for comparison, is called "withholding" and in the VAT it's a direct "labor tax" on the business.

If the VAT was actually used to eliminate all income taxes, this theory would have considerable merit. There is no doubt that personal and corporate income taxes do more damage per dollar raised than a VAT would ( Guseh, 1977.)

However, no nation has ever implemented a VAT (or a national sales tax) and used the money to eliminate all income taxes.

Indeed, no government in the world—national, state, provincial, county, or city—has taken this step. No government has even eliminated just one of the two forms of income taxation (personal and corporate). The VAT always has been imposed in addition to existing personal and corporate income taxes ( Grier, 1989.)

For example, with the Income Tax, a $100 wage may have $10 tax withheld by the employer leaving $90 for the employee. With the VAT, the employee would be paid $90 and the employer would be subject to a $10 labor tax. Other than how it's perceived, there appears to be no difference between a Value Added Tax and a truly flat, non-discriminatory Income Tax that's collected at the source of income.

• Numerical example:

Let us take a, seemingly straightforward, tax plan that would exempt saving and tax only consumption. Let us take Mr. Jones, who earns an annual income of $100,000. His time preferences lead him to spend 90 percent of his income on consumption, and save-and-invest the other 10 percent. On this assumption, he will spend $90,000 a year on consumption, and save-and-invest the other $10,000.

Let us assume now that the government levies a 20 percent tax on Jones's income, and that his time-preference schedule remains the same. The ratio of his consumption to savings will still be 90:10, and so, after-tax income now being $80,000, his consumption spending will be $72,000 and his saving-investment $8,000 per year ( Rothbard, 1977 )

"......Having challenged the merits of the goal of taxing only consumption and freeing savings from taxation, we can now proceed to deny the very possibility of achieving that goal, i.e., we maintain that a consumption tax will devolve, willy-nilly, into a tax on income and therefore on savings as well. In short, that even if, for the sake of argument, we should want to tax only consumption and not income, we should not be able to do so...." ( Rothbard, 1977 ).

Faced with this overwhelming real-world evidence, VAT advocates sometimes argue that the tax at least could be used to lower taxes on personal and corporate income. Just like the total replacement hypothesis, this partial-replacement hypothesis is an interesting theory, but it is equally implausible. All available statistics show that the aggregate tax burden on income and profits (a measure of the tax on personal and corporate income) has fallen slightly in the United States, but it has risen significantly in the European Union, and this increased tax burden on productive activity took place after VATs became ubiquitous ( Genetski, 1988.)

Property tax

Ad valorem property taxes are levied on real or personal property by local government units including counties, municipalities, school districts, and special taxing districts. As, ad valorem means a tax on goods or property expressed as a percentage of the sales price or assessed value, we are here in the domain of assessed values ( as it is the only way to get an estimate of the “sales price.”)

Role of property tax

Property tax is a tax that an owner of real estate or other property pays on the value of the property being taxed. The revenue from this tax is used by the local governments in developed countries to supply public services. These services range from those that exhibit mainly private goods characteristics, such as water, sewers, solid waste collection and disposal, public transit, public recreation, to those that exhibit mainly public goods characteristics, including local streets and roads, street lighting, fire and police protection, neighborhood parks, and so forth (Kitchen 2003). A property tax, millage tax is an ad valorem tax that an owner of real estate or other property pays on the value of the property being taxed. There are three species or types of property:

• Land,

• Improvements to Land (immovable man made things), and

• Personalty (movable man made things).

Real estate, real property or realty are all terms for the combination of land and improvements. The taxing authority requires and/or performs an appraisal of the monetary value of the property, and tax is assessed in proportion to that value. Forms of property tax used vary between countries and jurisdictions. Generally, ad valorem taxes are assessed as of January 1 of each year, and are computed as a percentage of the assessed value of the property being taxed. The assessed value of property generally means the annual determination of fair market value. "Fair market value" is usually defined as the price that a willing buyer would pay and a willing seller would accept for property, neither being under any compulsion to buy or to sell. It is also defined as the price at which property would change hands between a willing buyer and a willing seller when both have reasonable knowledge of all the facts necessary and neither is required to buy or sell. Appraisers hired by the taxing authority most often value the property. Most taxing authorities require periodic inspections of the subject property as part of the valuation process and establish appraisal criteria to determine fair market value. Such criteria include factors analyzing:

• the cost of the property and subsequent depreciation,
• comparable market data,
• the use of the property, and
• estimated annual net income generated by business property.

Evaluation of the property

All taxable properties must be identified and described on the assessment roll (with each property assigned a roll number) and, above all: assessed. The roll number is important for linking assessment information with tax billing and property transfer records. However, there is no uniform tax base that applies everywhere. In some countries, the property tax is based on property value as determined by:

• market value,
• site value, and/or
• rental value.

In other countries, the tax is based on building area and property area - this is referred to as unit value. In a few countries, a mix of these approaches is employed. Each of these systems is briefly considered below.

Market value

Market value is the price that is determined between a willing buyer and a willing seller in an arms length deal. Market value estimates the value that the market places on individual properties. For properties that sell in any year, market value is the selling price. For properties that do not change hands in the year, market value must be estimated. There are at least three estimation methods that may be used:

• First, when markets are active and similar properties are being sold in the same or comparable neighborhoods, a comparative sales approach could be used. This assigns a market value to an unsold property by looking at valid selling prices of similar or comparable properties.
• Second, a depreciated cost approach is sometimes used. This is most appropriate when properties are relatively new, there are no comparable sales, and improvements are relatively unique. Here, the property is valued by assigning a value to the land as if it were vacant and adding the cost of replacing the buildings and other improvements.
• Third, a capitalized income approach may be used. This is primarily for properties that generate actual rental income. Here, the annual net rental income (gross annual rental income minus annual operating expenses) is estimated with this annual net income subsequently converted to a capitalized property value (market value) using a capitalization factor.

EXAMPLE: To illustrate, if net annual rental income from a specific property is $10,000 and if the current interest rate is 5 percent (current rate of return on a bond, for example), the capitalized value of the property would be $200,000 (net rent divided by interest rate or $10,000/.05). This is also the market value because an individual would be willing to pay $200,000 for a property that generates an annual net rent of $10,000 – this is a 5 percent return and is identical to the return on bonds.

Site graded value assessment

Site value assessment (SVA) is a special case of market value assessment where only land is assessed. All capital improvements (buildings, for example) are excluded from the assessment base. Under a graded SVA system, capital improvements are included in the base and taxed at lower rates (sometimes significantly lower) than land, with the level of gradation varying according to the taxing jurisdiction's policies and practices. A form of site value assessment is used in New Zealand, Kenya, Jamaica, and South Africa (Bahl 1998).

There are two potential problems with site value assessment. Evidence is scarce on the effects of a system that taxes land more intensively than it taxes buildings. A study published in 1997 evaluated economic development in Pittsburgh, Pennsylvania after the city’s decision in 1979-1980 to adopt a graded system and apply a rate to land that was more than five times the rate on structures. The study concluded that Pittsburgh did experience a dramatic increase in building activity, one far in excess of any increases in other cities in the region, but it stopped short of concluding that the change in tax policy had caused the boom (Oates and Schwab 1997).

On the whole, it may seem that a graded system does encourage development, much of this development tends to be at the expense of neighboring communities that have not adopted a similar system and that replacement of the current property tax system with either a system that taxed land alone or a graded system would generate windfall gains and losses in the short run as tax bills rise for certain properties and fall for others (Bird 1993, 82).

• Unit-value assessment

On the other hand, support for unit-value or area assessment (based on size of property and buildings) has emerged in a couple of instances. First, it would be superior to value based assessment systems in countries or areas of countries that do not have fully functioning and operational real estate markets. Estonia, Poland, Czech Republic, Slovakia, Russia, and Armenia use it for this reason. Similarly, it may make sense to use it in parts of countries (Canada and Russia, for example) where there are isolated hamlets and no clearly functional market for property values because the government owns most of the housing and rents it to occupants.

Rental Value Assessment

In theory, tax on rental value should be equivalent to a tax on market value. In practice, rents reflect current use and not highest and best use, not to mention difficulties to estimate rental value when there are rent controls. Few issues are necessary to mention, here. Generally, an assessment has traditionally been based on relationship between the initial yield of a property at purchase and the rate of future rental value growth necessary to achieve a criterion rate of return on the investment. Thus — in calculations of the future rental growth rate required to justify an initial investment yield (when compared, say, to the rental shown by gilt-edged stocks) --- the simplistic view is taken that following purchase no further expenditure is anticipated. However, if a property is to maintain its original market appeal (or adapt to evolving circumstances), capital must from time-to-time be injected for the purposes of refurbishment. Thus, any analytical model which ignores this inevitable expenditure, but nevertheless assumes a constant rate of long-term future rental growth, is quite unrealistic.

Conclusion of Property Tax Methods

From the above text it is apparent that the most efficient, uniform, accountable, and transparent property tax systems around the world exist where the following conditions are met (Kitchen 2003):

• All taxable properties are identified, described and recorded on the assessment roll.
• The property tax base, whether assessed value or area value, is determined in a uniform and consistent manner across a region (as opposed to local) if not across an entire country.
• Assessment is updated as frequently as possible, ideally on an annual basis, so that the tax base is current, uniform, consistent and fair.
• Property assessment (determination of property values or property area) is the responsibility of an arms-length regional assessment authority in order to avoid local distortions created by local pressure groups.
• Each level of government using property tax revenues to fund expenditures is responsible for setting its own property tax rate(s).
• Variable tax rates are used when the cost of providing municipal services varies by property type and location.
• Variable rates, as opposed to a uniform rate, are more likely to discourage urban sprawl and to minimize the extent to which the local property tax is exported to other jurisdictions.
• Business properties (commercial and industrial) are not over taxed vis-à-vis residential properties.
• Limits (by a senior level of government) are not imposed on tax rates set by local governments unless it is to prevent local taxing authorities from imposing unnecessarily high rates on commercial and industrial properties vis-à-vis residential properties.
• The existence of a large number of municipalities in a region or country creates a competitive environment (where municipalities know what the tax rates are in neighboring communities) that provides an incentive for all competing municipalities to set their tax rate at the lowest possible level.
• Tax billing and collection is an administrative function that benefits from economies of scale and should, therefore, be administered on a regional basis.
• Caution should be exercised in creating specific property tax relief schemes – a better approach comes from implementing a comprehensive tax relief scheme administered by the regional or central government.

References

ISBN links support NWE through referral fees

• Bahl, Roy, “Land Taxes Versus Property Taxes in Developing and Transition Countries,” in: Dick Netzer, Land Value Taxation: Can it and will it work today?,.: Lincoln Institute of Land Policy, Cambridge, Mass.,1998, p. 144.
• Bickley, James “A Value-Added Tax Contrasted with a National Sales Tax,” Congressional Research Service, March 23, 2005
• Bird, Richard and Enid Slack, Urban Public Finance in Canada, 2nd edition, Wiley, Toronto,1993
• Engen, Eric M. and Jonathan Skinner, “Fiscal Policy and Economic Growth,” National Bureau of Economic Research Working Paper No. 4223, 1992.

• Genetski,Robert J. Debra J. Bredael, and Brian S. Wesbury, “The Impact of a Value-Added Tax on the U.S. Economy,” Stotler Economics, December 1988

• Grier, Kevin B. and Gordon Tullock, “An Empirical Analysis of Cross-National Economic Growth, 1951–80,” Journal of Monetary Economics, Vol. 24, No. 2 (September 1989), pp. 259–276.
• Guseh, James S. 1997. Government Size and Economic Growth in Developing Countries: A Political-Economy Framework. Journal of Macroeconomics 19(1):175–192.
• Kitchen, Harry “Local Taxation in Selected Countries: A Comparative Examination,” a paper prepared for CEPRA II, part C, 2003
• Oates, Wallace E., and Robert M. Schwab, “The impact of Urban Land Taxation: The Pittsburgh Experience” The National Tax Journal, vol.L, no. 1, 1997, pp. 1-21.
• Rothbard, Murray. 1977. Power and Market: Government and the Economy. Kansas City, KS: Sheed Andrews & McMeel. ISBN 0836207505.

External links

• http://www.investopedia.com/terms/a/advaloremtax.asp

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