The Fallacy of the Three-Legged Stool Metaphor
H. William Batt
[Reprinted from
GroundSwell, May-June 2005]
Tax experts, especially at the state level, ply their trade by
invoking one metaphor above all others: the three-legged stool. It
rests on the claim that a sound and successful tax regime for any
government needs to rely on three tax bases: income, property and
sales. This is repeated so often that it passes today without much
examination.
There seem to be three arguments for this:
- that taxes should be drawn from as wide an array of sources as
possible so as not to overburden any one base or sector.
- that the spread of tax burdens over a number of bases will
ensure greater stability and reliability.
- that reliance upon a wider number of revenue streams minimizes
the downside consequences which all taxes impose on the economy.
It is even claimed that revenue streams should rely on each such
base in roughly equal proportions, lest structural imbalances will
otherwise eventuate that jeopardize public support of government.
There are of course exceptions. States that have rich mineral wealth
have the luxury of imposing taxes that relieve them of the need to
rely equally on the big three. So also for states that have a rich
tourist industry or that can rely heavily on gambling revenue. But a
state is open to the charge that its revenue structure is
unbalanced, unfair, or worse unless such special circumstances
warrant.
Such wisdom is found most frequently in the literature of various
tax study commissions periodically constituted over the past thirty
years. Many of the staff directors of these bodies have circulated
from state to state as traveling emissaries, and it is not
surprising therefore that their official reports often bear a
striking resemblance to one another. Typically they address matters
such as the extent to which various taxes conform to the venerable
principles of sound tax theory (discussed further below), their
competitiveness with other political jurisdictions, and the balance
of revenue streams.
The Montana Committee study, chosen here simply as a typical
illustration, makes special effort to argue that elements of a high
quality revenue system are complementary rather than contradictory.
Taxes should complement each other so they provide a way to have all
economic activity and wealth contribute proportionally to supporting
government services. Taxes should not be just a number of different
methods to generate revenue from the same economic activity or
wealth; thus taxing some segments of society very heavily and others
sparsely.
It goes on to argue that a high quality state revenue system
reflects the limitations and financial responsibilities that state
government places upon local governments. State policy makers should
be explicitly aware of the costs that state mandates impose on local
governments, and local governments should have the authority to
raise sufficient revenues to meet these obligations. If local
governments lack the revenue bases necessary to provide services
mandated by state government, state policy makers should consider
statewide solutions to avoid extreme inequities. As an example, in
some instances, state government could consider subsidizing local
governments to reduce local tax burdens or increase service levels
for governments that lack enough taxing capacity to meet some state
standard of services. This approach, however, should be weighed
against the principle of local autonomy -- in which local voters
decide which services they want to receive and raise the money to
pay for them.
The Montana study reflects the conventional wisdom that a high
quality revenue system relies on a diverse and broad based range of
sources. One of the goals of a quality revenue system is economic
neutrality to prevent the distortion of individual and business
behavior. If reliance is divided among numerous sources and their
bases are broad, rates can be made low in order to minimize the
impact on behavior. A broad base itself helps meet the goal of
diversification since it spreads the burden of the tax among more
players than a narrow base does. And the low rates that broad bases
make possible can improve a state's competitive position relative to
other states. When possible, we should try to balance our tax
systems through reliance on the three-legged stool of income, sales,
and property taxes in roughly equal proportions, with excise,
business, gaming, and severance taxes, and user charges playing an
important supplementary role. In any instance, every attempt should
be made to avoid excessive reliance on any single revenue source.
The power with which the three-legged stool analogy has
underpinned tax policy is in fact rather disconcerting, because a
close examination of its premises shows that they are very
questionable. These benchmark measures of a tax regime are
scrutinized here in order to cast doubt on the claims so often made
on their behalf.
Taking first the argument that spreading the tax burden over as
wide a base of sources as possible, it is best to begin by noting
that revenue streams can be drawn from only three elements of the
economy: Land, Labor, and/or Capital. Standard textbooks for
Economics 101 typically start with recognition of these factors,
even if they usually give insufficient attention to Land as a
component. Classical economics, culminating particularly in the
tradition of Henry George, includes in the idea of Land any and all
components of value not created by human hands or minds. It
therefore means not just locational sites on the earth's surface
that might be bought and sold as real estate, but other elements of
so-called natural capital as well: the electromagnetic spectrum,
air, water, fish in the ocean, mineral wealth, airport time slots,
and so on. Those elements have a market price, and can be -- indeed
are -- often subject to taxation. It is important to note, however,
that taxes on such Land are capitalized in the market value of their
worth; they cannot be passed forward or backward because their
supply is essentially inelastic.
This is important, as will be noted below, because imposing such
taxes incurs no excess burden on their use or upon the general
economy. Taxing such bases is totally neutral and completely
efficient. Indeed, it is the failure to tax Land as stated that
leads to economic distortions and causes an economy to function at a
sub-optimal level. Land, whatever its form, has a market value only
to the extent that a human presence exists to make use of it, and it
acquires that value due to the accretion of economic rent, the
return that comes to rest on such factors.
Taxes on Labor and Capital, in contrast, are always shifted.
Studies of so-called tax incidence seldom trace the flow of tax
burdens beyond the first or second step of the shift. Textbooks and
research studies will note that particular burdens -- for instance,
a tax on the sale of goods -- will be partly borne by the vendor and
partly also by the consumer. The vendor in turn sees that tax
incorporated into the price he pays for the product at the wholesale
level; the consumer sees his burden reflected in the relative cost
of living of his tax jurisdiction -- which in turn affects the price
of his home and his wages. The shift in taxes, as economic theory
makes clear, are ultimately converted to rent, and that rent, as
capitalized in land prices, is its final resting place. It is a
truism of classical economics as carried through in the present day
tradition of Georgist economics that all taxes come out of rent --
an adage that has come to be abbreviated as ATCOR.
What this insight means is that all taxes not first imposed on
Land and collected from the rent that rests thereon are instead
passed through the economy from one party to another until they
ultimately come to rest on Land, thereby increasing the price of
real estate. The passing along of tax burdens not only creates
distortions in economic transactions; it also constitutes an excess
burden and an inefficiency that handicaps economic performance.
Taxing any form of Capital makes it more expensive and leads to less
saving and investment; taxing Labor, in the same way, depresses
wages and discourages enterprise. Contemporary economists and
conventional tax theorists well recognize that taxing Labor and
Capital is detrimental to economic vitality -- politicians thrive on
repeating this ad nauseum. Currently the Republican party candidates
seem best able to exploit resentment about the negative impact of
taxes. But they are not alone in failing to appreciate the nature of
tax shifting. What all fail to realize is that there are notable
exceptions to the rule that taxes are oppressive: any tax imposed on
an inelastic base -- that is, any form of Land -- constitutes no
distortion or excess burden whatsoever.
Far from spreading the burden of distribution over a wide array
of tax bases, the ideal tax, then, should be imposed solely on those
factors of production that form an inelastic base, i.e., that
constitute forms of Land -- whether they be locational sites,
natural resources, the spectrum, time slots, or others as they may
arise in the future. Land, in any of its forms, is totally
inelastic. Will Rogers in his pithy way said it well, Buy
land. They ain't making any more of the stuff. (Mark Twain
said it too.)
A second claim among advocates of spreading tax burdens over the
big three bases (and sometimes more if possible) is that it insures
greater reliability and stability of the revenue streams supportive
of government services. To be sure not all government services
require stable budgets -- motor vehicle licensure varies with the
state of the economy as do the needs of social welfare programs and
some offices related to capital investment. But most programs do
need to rely on predictable and stable financial support,
particularly education, health, and public safety. With revenue
streams based on formulas that vacillate from year to year, it
becomes difficult to provide for public needs, and the continual
political struggle over fiscal designs is frequently costly.
Economic cycles are accepted as a given in both government and
business circles. But there is compelling evidence that such cycles
have their roots in the tendency for elements of the financial
community to speculate in real estate, fostering bubbles in their
market prices that ultimately must be reconciled with the real
demand. Because the market price of Land is in good part a function
of the settling of rent, the recapture of that rent in the form of
taxation can both stabilize those markets and remove the cause of
those periodic cycles. By collecting only a miniscule element of
Land rent, and instead collecting revenue from Labor and Capital,
economic cycles are amplified and exacerbated, to say nothing of
their effect on productivity. Evidence of the stabilizing effect of
taxes on Land in the form of economic rent collection is shown best
by the fact that those nations and states that rely most heavily on
Land taxation are least subject to cyclical tendencies and
intermittent recessions. Japan, which imposes no tax on urban land,
has yet to recover from the crash in its real estate market almost
fifteen years ago.
The third claim, that reliance upon a wider number of revenue
streams minimizes the downside consequences that all taxes impose,
requires an extensive examination of the various options available.
What, first of all, are those aspects that must be avoided? What are
the standards against which various taxes can and should be
measured? These are typically listed as anywhere from four to seven
depending upon their description. Most common are neutrality,
efficiency, equity, administrability, simplicity, stability,
sufficiency. Tax theorists typically measure revenue structures
according to any or all of these criteria:
Tax neutrality refers to the influence (or absence of
such) that any particular design has on economic behavior. Typically
taxes are perceived as a damp on economic activity -- taxing income
reduces the incentive to work, taxing sales discourages retail
transactions, and taxing savings reduces the propensity to save. The
more a tax is perceived to be neutral the less the identifiable
distortions it imposes on the economy. The common assumption of most
tax theorists is that all taxes impose distortions; it's simply a
matter of which ones are least burdensome to economic health. A tax
which imposes no distortions is ideally best.
Tax efficiency is much like tax neutrality, and is the
measure of how much shifting of behavior it imposes, resulting in
what is called "excess burden," or "deadweight loss"
on the economy. Tax economists usually hold that the best taxes are
those that are shifted little if at all. Because the elasticities (a
technical word for the slope of supply and demand curves) of each
are very different, a tax on land values and a tax on improvement
values have very contrastive effects on economic choices. Using a
tax base that has little or zero elasticity is the best way of
assuring that taxes are not shifted. Zero elasticity is another way
of saying fixed supply.
The principle of equity is central to any discussion of
tax design. Tax design requires concern with both what is fair and
the extent to which it must sometimes be compromised to satisfy the
other principal criteria. Fairness can be evaluated according to
what is termed "horizontal equity" - the extent to which
those in similar circumstances will pay similar tax burdens, and "vertical
equity" - how well those in different classes bear different
burdens in the tax structure . It is this latter perspective that
leads to the use of terms like "proportional," "progressive,"
and "regressive" in referring to tax structures. A tax is
progressive with respect to income if the ratio of tax revenue to
income rises when moving up the income scale, proportional if the
ratio is constant, and regressive if the ratio declines. There is an
ancillary question of whether taxing to reach greater equity should
employ measures of income or of wealth, difficult as this is to
measure. Such questions of equity are a matter particularly central
when discussing the property tax. This will be discussed further
below.
Administrability refers to the ease with which a tax can be
administered and collected. Taxes which distort the economy are
inefficient but so are taxes that cost lots to administer. This is
measured not only in the direct costs of tax avoidance and
accounting expenses, but in the level of evasion and cheating, and
by the cost of government auditing and policing. When the taxpaying
public perceives that a tax is easily evaded, cumbersome, and
unfair, it loses its legitimacy and calls government itself into
question.
This is why the principle of simplicity is important: the more
complex the tax design, the more lawyers and accountants will find
loopholes, encourage the appearance of unfairness, and drive up the
cost of its administration. People know that with simple taxes other
parties are also paying their fair share, and all this enhances the
legitimacy and therefore the compliance of the tax system. Stability
refers to the ability of a tax to produce revenue in the face of
changing economic circumstances. Income and sales taxes, for
example, vary greatly according to phases in the economic cycle; the
property tax, in contrast, is highly stable regardless of the state
of the economy. This is one reason why school administrators have
typically been supportive of using the property tax base rather than
some other tax to support school services.
The certainty of a tax's collection ensures that the number and
types of tax changes be kept to a minimum. Frequent changes in tax
rates and bases interfere with business decisions and the ability to
make long-term financial plans. This concept reinforces the need for
stability because an unstable revenue system is more likely to
require continual adjustments.
In assessing the value of a tax it is also important, of course,
to understand its potential to bring in revenue for the purposes of
government, usually deemed revenue sufficiency. Income, sales and
property taxes, along with corporation taxes to a lesser extent,
have come to be regarded as the workhorses of the American revenue
structure. But, as anti-tax politicians are quick to note, the
higher these taxes are, the more they impose a drag on the economy.
This is why one should ponder whether to consider raising taxes
which have demonstrable distorting effects.
To be sure, the big three taxes all have negative consequences.
This is because all three are imposed largely on Capital and Labor;
only a minor component of taxes on property constitutes collection
of economic rent. Yet students of the real property tax readily
acknowledge that it has two components: that imposed on land values
and that imposed on improvements. When improvements are taxed at a
lower rate or when that levy is totally removed, it becomes a tax on
economic rent. Because that land is part of an inelastic tax base,
it is totally neutral, completely efficient, simple to understand
and to collect, a stable tax base, and easily administrable. This
last is particularly important: in recent years it has become
possible in principle to assess land value by computer algorithms
(called computer-assisted mass appraisal, or CAMA), completely
obviating the need for conventional eyeball assessors. Isobars can
be drawn on maps showing land values similar to the way elevations
in land topography are shown on geographic maps. The traditional
criticism of conventional property taxation, that assessment was
often arbitrary and subjective, no longer need be a compelling
criticism.
The one criticism often levied against the conventional property
tax is its regressivity. This is somewhat belied by the facts. Only
two empirical studies have ever been done on the subject, but both
concluded that the real property tax is mildly progressive. When the
two elements of the property tax are taken separately, it becomes
even clearer why this is so: the tax on the land component of real
property, being inelastic, cannot be shifted to tenants, and is
borne solely by the titleholder to the property. Only the
improvement part of the real property tax is in any way now shifted
to tenants, and its elimination means the most oppressive component
is gone.
When it comes to incidence of payment, the roughly 35 percent of
all American households who rent and do not own (largely poor
people) bear none of that tax burden whatsoever. Even among the
homeowning element of the American population, studies have shown
that a shift of the tax to land values typically lowers the burden
on about two thirds of all households. This is because tax districts
where homes are situated are typically not in highest land value
neighborhoods, and it is business and commercial sites --
particularly the underused land parcels in those neighborhoods --
that typically bear a larger burden. So in fact a tax on land values
is really a profound shift in the direction of progressivity.
If one realizes that houses, just like cars, refrigerators,
computers and other manufactured items, depreciate in value and that
only Land increases in market value due to the factors of inflation
and rent accretion, it will become clear that the remedy for onerous
real estate taxes is downtaxing buildings and uptaxing Land. The
result of doing so will stabilize tax burdens for those who
otherwise resent their payment. In the unusual cases, especially
during transitions, when titleholders of limited income cannot
manage such obligations, taxes can easily be deferred until owners
cash out by selling or dying when such debts can be settled. Sales
of appreciated land typically provide estates with adequate
wherewithal to both pay any back taxes and give a capital gain too.
And because business tenants continue to pay the going market rate
for office space, they too are in no way burdened by any tax shifts.
The upshot is that a tax on Land value alone -- totally neutral,
efficient, certain, progressive, stable, and administrable --
measures up so well that it looks like the perfect tax! It is even
argued that a land tax is better than neutral, in that it actually
fosters the kind of economic activity that fosters vibrant
communities. There are also very positive environmental effects
inasmuch as it removes, and even reverses, the centrifugal forces of
sprawl development and stimulates and facilitates investment in
urban cores. Evidence on this matter supports the claim that taxing
land alone is a more appropriate solution to both tax issues and
spatial configuration issues than any other public remedy,
particularly those that rely upon so-called command-and-control
approaches such as zoning and urban growth boundaries that foster
rent-seeking and further economic distortion. The failure of the
latter has been amply demonstrated, and constituted a major
conclusion of the Douglas Commission Report in the aftermath of the
riots in major American cities.
In the final analysis, studies show that very few states measure
up to the one-third - one-third - one-third standard in any case.
Political and other factors aside, there are good reasons for a
state's not abiding by such rules. It is only due to
misunderstandings that faith in the big three taxes constituting the
three-legged stool have come to prevail. When these taxes are
measured by their conformity with the conventionally accepted
principles of sound tax theory, they appear wanting. By shifting to
the collection of economic rent, manifest mainly in the form of land
value taxation, governments will better succeed not only in
overcoming the prevailing resentment against current taxation
policies but provide better financial support for those services
which are the rightful province of public obligation.