HOW should you tax wealthy homeowners? Britain's opposition Labour party thinks it has an answer: an annual mansion tax on homes worth over £2m. Meanwhile the Scottish government plans to reform taxes on house sales. Yet in the discussion over property taxes a favourite proposal of economists—a tax on the unimproved value of land—has been absent from the debate. Throughout history, economists have advocated such a tax. Adam Smith said "nothing [could] be more reasonable". Milton Friedman said it was "least bad tax". Yet there are only a handful of real-world examples of land value taxes (LVT). Why are they so popular yet so rare? When thinking about any tax, economists focus on how it affects decision-making. Income tax reduces the incentive to work. Corporation tax reduces the incentive to invest. Stamp duty deters some marginal house sales. Such prevention of mutually beneficial transactions is generally considered bad (though the deterrence of actions which hurt third parties—such as pollution—is an exception). Distributional effects also matter, although are often ignored on the assumption that any redistribution can happen through separate mechanisms.

Land value taxation is so beloved of economists because, in theory, it does not distort decision making. Suppose a land value tax of one per cent on land value is introduced tomorrow. There can be no supply response: there would still be as much land as there is today. Neither would consumers’ preferences change, as land would be no more useful, either. So if the market for land is competitive, no transactions would be deterred or encouraged. All that changes is the price, which falls until it exactly offsets the discounted cost of paying the tax forever. The buyer assumes the burden of paying the tax, so all things considered is no better or worse off. Landlords are unable to pass the tax on to tenants, because the supply and demand of rented land is unchanged too. Furthermore, if LVTs replaced property taxes, incentives against improving homes and developing land would be removed. Yet LVT would continue to account for "undeserved" gains landowners make on the investment of others, such as the government improving nearby transport links (this feature of the tax appealed to Winston Churchill).

But if LVTs are so great, why are they so rare? One explanation is that it is too difficult to value land separately from what sits on it. There is not much of a market, for example, for undeveloped land in central London. However, some think this can be overcome. The 2010 Mirrlees Review of British taxation argued that bean-counters could compare the price of similar buildings in different locations, for instance. In any case, the efficiency of the tax does not depend on accurate valuations. The bigger barrier is political. LVTs would impose concentrated costs on today’s landowners, who face a new tax bill and a reduced sale price. The benefit, by contrast, is spread equally over today’s population and future generations. This problem is unlikely to be overcome. Economists will continue to advocate LVTs, and politicians will continue to ignore them.

Dig deeper:

Proposed changes to property taxes are far from perfect (Oct 2014)

Governments should make more use of property taxes (July 2013)

Why an influx of foreign money is good for London's housing market (Nov 2013)