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.

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

An ad valorem tax is typically assessed when property is purchased, in the form of a sales tax or value added tax (VAT), although 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 in the form of tariffs, and in other circumstances where property of value changes hands, such as inheritance tax. It may also be charged on land alone, known as land value tax.

Types of Ad Valorem taxes

Ad valorem taxes can be based on ownership of a real asset, such as property taxes, or they can be "transactional taxes," such as sales taxes. While property taxes are determined and levied annually, transactional taxes are levied only at the time of a transaction.

The most common ad valorem taxes today are property taxes levied on real estate. Ad valorem property taxes are typically a major, if not the major, revenue source for both state and municipal governments. Municipal ad valorem property taxes are commonly referred to as simply "property taxes."

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. Real estate, real property, or realty are all terms for the combination of land and improvements.

An owner of real estate or other property pays this tax on the value of the property. The revenue is used by the local governments in developed countries to supply public services which 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).

As ad valorem means a tax on goods or property expressed as a percentage of the sales price or assessed value, these are in the domain of assessed values (as it is the only way to get an estimate of the “sales price.”) There are three species or types of property:

• Land,
• Improvements to Land (immovable man made things), and
• Personal property (movable man made things).

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 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. 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.

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. A mix of these approaches may also be employed.

Land Value Tax

Land value taxation (LVT) (or site value taxation) is an ad valorem tax where only the value of land itself is taxed. This ignores buildings, improvements, and personal property. Because of this, LVT is different from other property taxes on real estate — the combination of land, buildings, and improvements to land. Every jurisdiction that has a real estate property tax has an element of land value tax, because land value contributes to overall property value (Ginsberg 1997).

Far from being a new idea, or the idea of a small group of thinkers, land value taxation is a concept embraced by many of the most important figures of history: John Locke, Adam Smith, Thomas Paine, Thomas Jefferson, and more recently Milton Friedman (Foldvary 2006).

In 1879 Henry George published Progress and Poverty, which significantly influenced land taxation in the United States. Based on his observations, Henry George became a strong proponent of a single tax on land, known as the "land value tax," based on the unimproved value of the land, which is the value that the land would have in its natural state. This idea was not new, but based on David Ricardo's theory of rent. George, however, suggested that the tax levied on unimproved land would be sufficient to support all government programs, thus being the "single tax." George's argument was to tax the rent of land and natural opportunities—that is, to recapture rent for public use—rather than to tax labor and capital.

Most taxes, noted George, stifle productive behavior. A tax on income reduces people’s incentive to earn income, a tax on wheat would reduce wheat production, and so on. But a tax on the unimproved value of land is different. The value of land comes from two components, its natural value and the value that is created by improving it (by building on it, for example). The value of a vacant lot in its natural state comes not from any sacrifice or OPPORTUNITY COST borne by the owners of the land, but rather from DEMAND for a fixed amount of land. Therefore, argued George, because the value of the unimproved land is unearned, neither the land’s value nor a tax on the land’s value can affect productive behavior. If land were taxed more heavily, the quantity available would not decline, as with other goods; nor would demand decline because of land’s productive uses. By taxing the whole of the value of unimproved land, the government would drive the price of land to zero.

Joseph Stiglitz proposed the following theorem, based on this idea:

In a simple spatial economy, where the spatial concentration of economic activity is due to a pure local public good and where population size is optimal, aggregate land rents equal expenditure on the pure public good. This result has been dubbed the Henry George Theorem (HGT), since a confiscatory tax on land rents is not only efficient, it is also the “single tax” necessary to finance the pure public good (Stiglitz 2002).

Practically, at question there is the shift from taxing productive human action to collecting the economic rent generated by nature and communities. This is, however, more than a fiscal reform. There is a philosophical and even spiritual side to this reform.

One of the ongoing problems of social philosophy is the relationship of the individual to society. In conventional tax policy, there is an inherent conflict between the individual and government as the agent of society. Individuals want to benefit from the collective services provided by government, but the mechanisms for financing those services typically have used force against individuals and invaded their private lives (Foldvary 2006).

The collection of land rent for public revenue reconciles the individual and the community. The community and its government no longer intrude into the individual’s private life and stifle his or her pursuit of economic well being. The tax on land value is not a tax in substance, but only in the form of payments to government. In substance, the payment is a sharing of the benefits provided by community and nature, and a payment for the services that generate the value of the land. If this payment is not made by the landholder, the services become a subsidy, producing a value not returned to the community.

The public collection of land rent can induce an efficient use of land. Land value taxation gives land a “carrying cost,” inducing title holders to put their land to its most productive current use, rather than hold it awaiting higher prices. With the price of land thus kept low, banks would lend for productive investments rather than to buy land (Foldvary 2006).

Finally, William Vickrey believed that "removing almost all business taxes, including property taxes on improvements, excepting only taxes reflecting the marginal social cost of public services rendered to specific activities, and replacing them with takes on site values, would substantially improve the economic efficiency of the jurisdiction." (Vickrey 1996) Thus, he had been well aware of the famous Rothbards’ axiom that the conventional criteria of justice in taxation are invalid (Rothbard 2004).

NOTE: Rothbards’ axiom in a nutshell, has made it clear that the only possible objective criterion for the just price is the market price. For the market price is, at every moment, determined by the voluntary, mutually agreed-upon actions of all the participants in the market. The "just price" was thus, to certain extend, abandoned in favour of the market price. “…But…can the "just tax" be abandoned in favour of the market tax? Clearly not, for on the market there is no taxation, and therefore no tax can be established that will duplicate market patterns….. there is no such thing as a "neutral tax" — a tax that will leave the market free and undisturbed — just as there is no such thing as neutral money….”( Rothbard 2004).

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 of the value of the item 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 sales taxes may also be 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.

Value-added tax (VAT)

The Value Added Tax (VAT) is a form of consumption tax that taxes all business profit and labor. It was invented in 1954 by French economist, Maurice Lauré, joint director of the French tax authority. By the end of the twentieth century it had been adopted throughout the European Union and in many countries in Africa, Asia, and South America. Notably, the United States and Canada did not follow suit.

The tax is levied on the value added to the product at each stage of its manufacturing cycle as well as the price paid by the final consumer. Commonly, the seller at each stage subtracts the sum of taxes paid on items purchased from the sum of taxes collected on items sold; the net tax liability is the difference between tax collected and tax paid. The cost of materials, subcomponents, tools, equipment, facilities, supplies, and so forth, and any services purchased from other businesses, are not retaxed under the VAT. Those purchases would have already been subjected to the VAT by the supplying businesses.

The burden of VAT, like other consumption taxes, tends to be passed on to the consumer. Additionally, since this is a regressive tax, lower income people have the greatest burden. To offset this, necessities are often taxed at a lower rate than luxury items. Advocates of the VAT contend that it is an efficient method of raising revenue, and would permit concomitant reductions in income tax. Opponents argue that, as a regressive tax, it puts too much burden on those who are least able to afford it.

Applications of ad valorem taxes

United States

"...The historic decline in the role of the property tax mostly reflects the decision, within the fifty state-local fiscal systems, to replace local property taxes with state (and, to a much lesser extent, local) nonproperty taxes..."( Netzer 2000: 54.)

"...One of the more important trends in property taxation has been the removal of personal property — property that is not land or buildings — from the tax rolls: Personal property fell from 17% of the tax base in 1956 to 10% in 1980..." (Netzer 2000:59.)

Another trend is for state governments to tax land based on its current use, rather than its market value.

"Except in wholly nonurban states, the actual economic value in the current uses often is far below the market value for alternative uses; in practice, farmland tends to be drastically underassessed even on a current-use basis." (Netzer 2000:60.)

Hence, as personal income tax is not allowed in most USA jurisdiction, ad valorem taxes (mainly real property tax and sales taxes) are a major source of revenues for state and municipal governments.

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%. Latest ( i.e. in the year 2009 ) combination of more or less opaque taxes in Canada yields a 15% Tax everybody has to pay for any goods and services rendered.

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 (EU). 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.

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 also a 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.

Positive and negative aspects of ad valorem taxes

What has VAT achieved in EU is 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).

We have said above that value-added tax (VAT), or goods and services tax (GST), is a 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).

EXAMPLE 1: 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.

EXAMPLE 2: 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).

Conclusion

Let us start with Henry George’s single tax theory. George was right that other taxes may have stronger disincentives, but economists now recognize that the single land tax is not innocent, either. Site values are created, not intrinsic. Why else would land in Tokyo be worth so much more than land in Mississippi? A tax on the value of a site is really a tax on productive potential, which is a result of improvements to land in the area. Henry George’s proposed tax on one piece of land is, in effect, based on the improvements made to the neighboring land.

Secondly, Murray Rothhbard ( Rothbard 2004 ) and Hans Hoppe ( Hoppe 2001: 13 ) made an excellent case that a free-market society can operate without a government.Hoppe contrasts the theoretical model of unrestrained democracy with that of absolutism. He claims that an absolute monarchy gives the king property rights over the entire country: he owns everything. Since he has an interest in keeping the value of the property up, he and his staff will be forward-thinking, and pass policies that will not wreck the economy because he will suffer as a result of this. He mentions that the first French kings considered themselves to be in debt to the people for justice (Hoppe 2001: 20), and finally he claims that: “ In a regime of universal suffrage, combined with the fact that some people earn more than others and that the ability to acquire real riches is confined to a small minority, it's only a matter of time before the general public figures out that they can use the franchise to take the wealth out of the rich people's pocket. This makes the political exploitation worse because under democracy, there's no authorities above the fray that the target can run to for protection…..”( Hoppe 2001).

Thirdly, for those who believe markets generally allocate resources efficiently, the best tax is one which creates the least distortion of market incentives. A tax on the value of land meets this criterion. Furthermore, the benefits of local government services will be reflected in the value of land within the locality. Therefore, it may be deemed fair that landowners pay taxes to finance these services in proportion to the value of the benefits they receive. Although Henry George advocated a tax on land values as the "single tax" to replace all other taxes, a tax on land value seems especially appropriate for municipal governments. If a complete shift from the current property tax to a tax on land value alone seems too radical, municipal governments might reduce the property tax rate on improvements while imposing a higher tax rate on the value of land. But that’s not Henry George any more.

And finally, let us hear Jean-Baptiste Say, who contributed considerably more to economics than Say's Law. Say was under no illusion that taxation is voluntary nor that government spending contributes productive services to the economy. Say pointed out that, in taxation:

“……The government exacts from a taxpayer the payment of a given tax in the shape of money. To meet this demand, the taxpayer exchanges part of the products at his disposal for coin, which he pays to the tax-gatherers……” (Say 1880).

Eventually, the government spends the money on its own needs, so that in the end

“. . . this value is consumed; and then the portion of wealth, which passes from the hands of the taxpayer into those of the tax-gatherer, is destroyed and annihilated….” (Say 1880).

Note, that as is the case with many later economists, such as Murray Rothbard, Say sees that taxation creates two conflicting classes, the taxpayers and the tax-gatherers:

“……Were it not for taxes, the taxpayer would have spent his money on his own consumption. As it is, the state. . enjoys the satisfaction resulting from that consumption…..” (Say 1880).

Taxation, then, for Say is the transfer of a portion of the national products from the hands of individuals to those of the government, for the purpose of meeting the public consumption of expenditure:

“……..It is virtually a burthen imposed upon individuals, either in a separate or corporate character, by the ruling power... for the purpose of supplying the consumption it may think proper to make at their expense…..” (Say 1880, 446).

But taxation, for Say, is not merely a zero-sum game. By levying a burden on the producers, he points out, "taxes, over time, cripple production itself."

“……Taxation deprives the producer of a product, which he would otherwise have the option of deriving a personal gratification from, if consumed... or of turning to profit, if he preferred to devote it to an useful employment... Therefore, the subtraction of a product must needs diminish, instead of augmenting, productive power…..” (Say 1880, 447).

J. B. Say's policy recommendation was crystal clear and consistent with his analysis and that of various comments on VAT:

".....The best scheme of [public] finance is, to spend as little as possible; and the best tax is always the lightest..." (Say 1880)

Amen.

References

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