Business rates are a tax on landlords, not on businesses

There is such a thing as a bad tax cut, and business rates relief for small businesses is one of them. Despite what the Chancellor claimed in his budget yesterday, reducing rates will likely be a tax cut for landlords, not businesses. Business rates are a tax on non-domestic property, paid by the occupier rather than the owner and based on the property's rentable value. Since they are paid by the renting business, most people assume it is businesses who lose out because of them.

In fact, the burden of the tax seems to mostly fall on the property owners, not the firms occupying them. This is because when rates are cut, rents rise in proportion to that cut. Lower rates means higher rents. That means that the level of business rates makes no difference to the operating costs of businesses that rent their premises, and cuts to business rates will end up giving money to landlords, not business.

The theory, at least, goes like this: Because supply of land is fixed, the total rental value of a property is determined entirely by demand – how much would-be renters are willing to pay to rent there.

Firms think in terms of the total cost of occupying somewhere, and the division between rates and rents is not relevant to them. They don’t care who gets the money, they care about how much it costs, all in all, to be located somewhere. When the amount they have to spend on rates rises, the amount they can spend on rents falls. When rates fall, the amount they can spend on rents rises.

This theory is borne out by empirical evidence. In 2003 Dr Nigel Mehdi looked at the introduction of the Uniform Business Rate in 1990, which replaced property taxes that differed greatly before then. He found that, across London, property values adjusted so that total occupancy costs between matched properties equalized over time. In other words, where rates fell, rents rose; where rates rose, rents fell.

The Institute for Fiscal Studies’s 1996 paper “Who Pays Business Rates?” looked at the same event on a national level and produced a similar finding, in the long run.

But how long is the long run? In the time it takes for rents to rise (as old rental agreements expire and new ones are made), businesses will capture the reduction in rates. But this may not be very long. A recent paper by the British Property Federation looked at five revaluations between 1990 and 2010 and found that within two to three years 75% of the value of a business rates change had been factored in to rents.

So while we should expect this business rates exemption to fairly quickly be offset by higher rents, how does the fact that small businesses only are exempted factor in? I’m less sure about this, but I suspect we may see a similar effect to what happens with Housing Benefit. Rents will rise overall, but recipients of the exemption (small businesses) will end up being slightly better overall. Unfortunately this comes at a cost to other businesses, and most of the benefit will go to landowners.

There is also the “Francification” problem of having hard cut-off points for business benefits based on their size (which the small business exemption does, based on property values). Hard cut-offs lead to situations like France’s where firms cluster at the cut-off point – the chart above shows how many firms have restricted themselves to 49 employees to avoid all the legislation that kicks in for ‘big’ firms with 50 employees or more. The second problem is that small businesses are not inherently better than big businesses, and benefiting them at the expense of larger firms is likely to be wealth-destroying overall.

Business rates are bad mostly because they tax the property value, rather than the underlying land value, so they disincentivise investment in better property or machinery (when that machinery is rateable). A wise Chancellor would move rates to being a tax on the land value alone, and skip the destructive gimmicks like this one.