Business rates: not such a good tax after all

Taxes, eh? Just when you think you’ve found a good one, it lets you down. We usually think of business rates as some of the least bad taxes we’ve got, because to a large extent they’re like land value taxes. Land value taxes are far from perfect but they do less harm than most taxes. For a start, they tend to fall on landowners, rather than land occupiers, because the supply is fixed. Tim Worstall explains this here, and the empirical evidence is quite strong that a £1 rise in rates leads to a nearly-commensurate fall in rents over the long term.

They’re also less distortionary. A good rule of thumb is that if you tax something, you get less of it, which is why taxes on capital are such a bad idea. But since there’s a fixed supply of land, taxing the value of land doesn’t get you less of anything. Nice one.

Unfortunately this might not be how business rates really work, because they tax the value of property rather than land. To a large extent this is a tax on land and that’s all fine and dandy, but you’ll notice that a five star hotel costs more to stay in than the Bates Motel next door, even though the land they’re built on is worth the same. This is because the actual bricks and mortar on top of that land have different values too.

The British Property Federation (and chums) have a new report out today which points out that this might be a serious flaw in business rates. They argue that most landowners have other investments too, and will shift their money from property to those investments when business rates rise:

A rise in business rates will reduce the rents that a landlord is able to achieve and therefore reduce the potential level of new real estate investments by a sum equal to the value of the tax burden transferred from occupiers to landlords business rates … If a proportion of business rate increases are capitalised into lower rents, then there is a likelihood that this will impact on the level of new funded commercial development.

That’s an important point – I’m not sure about the numbers they use, which suggest an extremely high elasticity of investment that I don’t think is justifiable, but it’s still an important point.

Just as important: the less frequently revaluations are done, the more uncertainty there is in the system. Uncertainty is a deadweight loss – it destroys wealth and makes everyone worse off. As we’ve pointed out, it’s not difficult to estimate property values on a rolling basis.

What’s really interesting about this report is not just what it’s saying but who’s saying it. Most industry bodies are woeful on business rates – they wrongly assume that the incidence is on firms because they’re the guys writing the cheques. For the BPF to come out and reject this – and do so with reference to most of the existing academic literature, no less – is very encouraging. But they do have a point about the investment effect.

So, must we throw business rates on the scrapheap too? It depends on the elasticity of investment – how much less money goes on property investment when rents fall after rates rise. And the way to fix things is quite simple: tax the value of the land, not the property that’s built on it.