Policy trade-offs in designing a tax system

There are three main decisions policymakers will need to take in reforming or introducing land and/or property taxes:

What exactly to tax?

When a property is sold on the market, the value of this property is usually the sum of value of land and the value of the immovable property on this land.

Policymakers can choose to tax land but not immovable properties, immovable properties alone, or some combination of land and immovable properties. In Tanzania, for example, the value of immovable properties is isolated and only this is taxed, whilst in Rwanda, Malawi, Zambia and Botswana, the value of land and property are isolated but both taxed separately. In Kenya, the value of land without immovable properties is isolated and taxed. In Lagos, three different rates on land and property have been consolidated into one land use charge.

Taxing the value of immovable properties alone lacks many of the benefits of taxing land, or land and property together. As the value of buildings is not affected by public investments or population growth, but only on the cost of construction and years of depreciation, this does not allow governments to capture rising land values that are publicly created. At the same time,
these taxes are less efficient than taxing land alone, as they may discourage investment in properties. Taxing land alone may encourage landowners to use their land more intensively by raising the cost of holding underdeveloped land. High levels of land taxation, alongside lower taxes on productive sectors, have reduced land speculation and encouraged manufacturing investment in many East Asian countries 8.

However, taxation on properties can play an important role in redistributing wealth as a tax on assets. This, alongside certain practical considerations,
may mean that taxing land and properties together is the best option for policymakers. Two such considerations are data availability and taxpayer understanding. If there is insufficient data on transactions of land and property, or on the current value of buildings alone, it is difficult to isolate the separate values of land or property. It may therefore be easier to value and tax land and property together. Taxpayers are also far more likely to understand a tax system based on the composite value of land and property because they are likely to be more aware of the market value of the two assets combined.

What assets are exempt from taxation?

A major factor affecting revenues from land and/or property taxes is whether or not exemptions are introduced, which can be based on land or property use, value, or ownership. In a number of developing cities, exemptions to land and/or property tax systems are a significant source of revenue loss. Exemptions can be divided into five main groups:

  1. Those based on socially desirable land and/or property use, such as schools and hospitals;
  2. Those targeting owners with lower value assets in order to reduce inequality, based on the value of land or properties;
  3. Those targeting owners who would not be able to afford to remain on their land/ property if taxed based on its value, e.g., low income households;
  4. Those given for political reasons, such as owner-occupancy exemptions to garner political support from homeowners;
  5. Exemptions for government-owned properties and non-profit enterprises.

There are benefits to implementing land and/or property tax exemptions.  The first three types of exemptions outlined above can be useful in achieving different goals for urban development. At the same time, exemptions to low value land/and property may be sensible if administrative costs outweigh potential revenues. Low-income exemptions may also be necessary in the short run, to reduce political resistance to reforms that displace low-income groups without alternative living arrangements.

But there are also significant downsides, as experienced in many developing cities. A well-functioning tax system is one that applies a low tax rate across a broad tax base. Exempting some properties from the tax base does not reduce overall demand for public investment in services and infrastructure, and therefore either reduces tax intake or places a higher tax burden on all other individuals.

In addition, by introducing any kind of exemption, land and property tax systems are made more complex. This creates the opportunity for fraudulent behaviour. Exemptions for owner-occupancy, for example, can be exploited by owners of multiple plots of land by dividing ownership titles among family members to avoid taxation. With greater complexity comes greater administrative burdens on local governments to monitor and evaluate requirements for exemptions. Any attempts to increase the range of exemptions should be carefully weighed against administrative capacity to monitor qualification for such exemptions.

Land used for schools are often exempted – School in Kigali, Rwanda. Photo: Brian Dolinger, 2009.

How to set land and property tax rates?

Setting a tax rate is a difficult policy decision since it involves weighing the need to raise municipal revenues against the ability of taxpayers to pay. Given the tax base, and how much a government aims to raise from land or property tax, a tax rate can be determined – as long as it satisfies affordability constraints for taxed individuals.

A house is typically seen as affordable if it is 2-3 times the owner’s annual income

The affordability of land and/or property taxes depends on a range of factors, including taxpayer incomes and other taxes they pay – including other taxes on land and/or property, such as capital gains tax. Given that a house is typically seen as affordable if it is 2-3 times the owner’s annual income 9, property values can give a rough idea of owner incomes, which can be used to estimate what percentage of incomes would go towards any particular tax rate.

Tax rates across the world

Land and property taxes across Europe and in the US are typically set somewhere between 0.5-1% of market value per annum.10 In East Asian countries such as China and the Philippines, property tax rates are approximately 1-2% whilst annual property taxation in South Korea is levied between 0.15 and 0.5% of property values.1112

In many sub-Saharan African countries, high tax rates are applied to outdated asset values – in Kenya, for example, land taxes range from less than 10% to over 30%.10 In others, however, rates can be much lower; in Rwanda, taxes on land and buildings under freehold titles are set at only 0.1% of asset values.14

In many developing cities, different rates are often applied to land and property based on whether they are used for residential, commercial, or industrial purposes. At the same time, tax rates are sometimes differentiated by area if there are certain public services that only benefit particular areas in a city 15. Variable tax rates can be beneficial in a number of cases. Higher tax rates on vacant or underdeveloped land alone, for example, can be key to reducing land speculation, where land is bought by investors as a short-term investment with no intentions to develop it. In Gaborone City in Botswana, for example, land tax rates on underdeveloped plots are four times higher than on developed plots, in order to discourage speculation and encourage rapid development16. Policymakers may also want to capture a greater proportion of the value of residential properties that generally make greater use of public services and infrastructure than non-residential properties.

In Gaborone City, Botswana, land tax rates on underdeveloped plots are four times higher than on developed plots, in order to discourage speculation and encourage rapid development

However, introducing variable tax rates can, like exemptions, increase complexity of the tax system, and raise associated administrative costs in its implementation. Differentiating between types of land/property or their values substantially increases the data requirements, increases the opportunity for error in judgement, and face similar administrative challenges as implementing exemptions. In addition, the more complex the system of tax rates, the more difficult it is to communicate the system transparently to taxpayers. If administrative capacity is low, a single rate may be the best option for policymakers.

Footnotes

  • 8 Kopanyi and Murray, ‘An Effective Property Tax Regime for Rwanda (Draft Report)’.
  • 9 Sally Murray, Mihaly Kopanyi, and Patrick McSharry, ‘A Land Value Tax for Kigali: Analysis and Policy Considerations’ (IGC, 2016).
  • 10 Kopanyi and Murray, “An Effective Property Tax Regime for Rwanda (Draft Report).”
  • 11 Global Property Guide, “China Capital Gains Tax Rates, and Property Income Tax,” Text, Global Property Guide, (2013); Global Property Guide, “Philippines Capital Gains Tax Rates, and Property Income Tax,” Text, Global Property Guide, (2016)
  • 12 Global Property Guide, “South Korea Capital Gains Tax Rates, and Property Income Tax,” Text, Global Property Guide, (2016)
  • 13 Kopanyi and Murray, “An Effective Property Tax Regime for Rwanda (Draft Report).”
  • 14 Ibid.
  • 15 Richard M. Bird and Enid Slack, ‘Land and Property Taxation: A Review.’, in Paper Presented at the World Bank Land Workshop, April 3–6, Budapest, Hungary., vol. 19 (Citeseer, 2002).
  • 16 Alosyus Mosha, Challenges of Municipal Finance in Africa: With Special Reference to Gaborone City, Botswana, Human Settlements Finance Systems Series (Nairobi: UN-HABITAT, 2010).