Stamp duty has long been the bane of first home buyers, but could the writing finally be on the wall? Michael Janda takes a closer look at the archaic, inefficient and onerous tax, and explains why it needs to go.

Sometimes the smallest governments can spark the biggest national reforms, and virtually all economists are hoping that the ACT is doing just that with its plan to abolish stamp duty.

For those not familiar with the plan, the ACT is proposing to phase out stamp duty gradually over the next 20 years, replacing the lost revenue with an increase in general rates, effectively a land tax.

Almost all economists are cheering the move - if it survives through to completion - with stamp duty rated by the profession as one of the most inefficient revenue-raising measures, and land tax one of the best.

It will not just be economists cheering, with stamp duty currently one of the biggest upfront costs acting as a barrier to people buying their first home or needing to move. One study by a prominent housing economist found it makes up almost a quarter of the average upfront costs faced by first home buyers (with the deposit, moving and legal costs among the other major imposts).

The difference between stamp duty and these other costs is that it is easily avoidable - if state governments have the stomach for genuine tax reform.

An archaic tax

Stamp duty is an archaic tax, an historical vestige from a bygone era where governments had little knowledge or control of vast areas of their realm.

Back in the early 19th century, the need to have many documents officially stamped to make them legally binding (such as property transfers) offered the best opportunity for a government to levy its taxes and minimise tax evasion.

However, for well over a century, Australian states have had comprehensive property registers under the Torrens Title system, meaning governments know who owns what property at any point in time, making a land tax easy to administer.

Yet, despite land taxes (and council rates, which are also land taxes) being in place in many states for a long period of time, stamp duty still persists as the principal way to raise revenue from real estate.

This surely has to be a function of laziness about the hassle of changing to a different tax system, as well as the irrational fear that the phrase 'land tax' generates, even if it were expanded just to replace the revenue forgone by eliminating stamp duties.

Unlike stamp duties, which are partially hidden among the raft of other costs associated with buying a home, land tax comes in a separate bill - an annual reminder of money paid to the government. And it is called a 'tax'.

No logic

Other than these superficial political and branding issues around property taxation, there is no economic logic to retaining stamp duties over a broad-based land tax.

From a home purchaser's perspective, stamp duty comes at the worst possible time, on top of a raft of other costs - the deposit for the home, the legal costs of conveyancing, removals, the purchase of necessary household goods, and bank fees.

First home buyers must save that extra money - often more than $20,000 - before they can enter the market, and many may effectively borrow the stamp duty by taking out a bigger mortgage from the bank than they would have if they had not had to pay the duty.

A land tax, like stamp duty, will tend to reduce the price of a property because it gets factored into a purchaser's decision about how much to pay (just like strata levies or council rates) but, unlike stamp duty, it is not payable upfront.

Replacing stamp duty with a land tax can almost be seen as a loan from the government to home buyers - it still gets its tax, but spread out over time, not upfront.

From a government perspective - other than perhaps politically - land tax is also a no-brainer over the long-run. Once any transition period is over, a land tax designed to replace stamp duty should raise just as much revenue, but it will do so far more consistently.

That is because land tax revenue fluctuates with property values, while stamp duties fluctuate with values and transaction volumes, which can be highly volatile.

The Henry Tax Review cited the example of sales of established homes in Sydney, which plunged 19 per cent between 2007 and 2008. In response, stamp duty raised by the NSW Government fell more than 30 per cent, from $3.94 billion in 2007-08 to just $2.74 billion the next financial year, an instant $1.2 billion budget black hole.

In contrast, land tax revenues only fluctuate with the value of land, which tends to be more stable, and also rise over time with increasing wages and population.

Economic inefficiencies

However, it is the economic inefficiencies that stamp duty generates, and the status of land tax as one of the most efficient taxes, that has most economists supporting a shift.

The biggest problem with stamp duties is that they are transactional, and therefore avoidable by not buying or selling property.

Economic logic, and several studies, have confirmed that stamp duties do act as a significant deterrent against people changing homes. This leads to a sub-optimal allocation of the nation's housing stock - i.e. people stay in homes that are too small or too big, or in an inconvenient location, simply because it would cost them so much money to move.

This tendency for home owners to stay put also helps partially explain Australia's relatively large average home sizes (Australian households have amongst the most floor space per person of homes anywhere in the world).

That is both because older residents are continuing to take up much of the larger housing stock due to the financial disincentive against downsizing, and also because younger purchasers will tend to buy a property that is bigger than their current needs to avoid having to buy another in the near future as their family grows.

The same effect also means that Australia's workforce becomes less mobile, as people have a strong financial disincentive against moving to take up a job, or a better job.

The lack of mobility is a factor in pushing up labour costs disproportionately in boom areas and unemployment in those locations stuck in economic downturns. It also means people are less likely to shift homes within the same city after taking up a new job in a different area, thereby increasing the average commute.

Workers who have to move frequently are either financially discriminated against by paying more tax in stamp duties, or forced to remain as renters because the duties would be prohibitive.

Under Australia's tax system, people who spend their whole lives renting end up missing out on the benefits of home ownership, such as tax-free capital gains.

Transitional arrangements

With so little going for them, stamp duties are surviving on the inertia of politicians for whom change equals potential threat.

The ACT model presents one way around the potential shock of change, which is to phase the stamp duty reductions and rate increases in so gradually as to avoid any sudden jolt to the property market.

The Henry Tax Review suggested a more novel approach to transition which might also address some of the political concerns of people who have already paid stamp duty on their current property. That would be to restrict the new land tax to properties changing hands after a particular introduction date, so that those who already paid stamp duty are not taxed twice.

This proposal goes a step further and suggests that buyers of properties after this date could be offered a choice: either pay stamp duty up front, or agree to pay land tax into the future at a rate set that would roughly equal the stamp duty they would have had to pay plus inflation.

Once a property had switched onto land tax, however, it could not switch back onto stamp duty the next time it was sold. Gradually, almost all of the housing stock would move onto land tax, at which time, decades hence, another transition arrangement could be made for the few properties left that were not yet covered by land tax.

The government might lose some upfront revenue in the short-term, but in return would receive a much more stable long-term source of income. First time buyers would be no worse off, because the land tax was simply replacing the amount of stamp duty they would have had to pay, and they may be better off, because the lower upfront costs mean they may need to borrow less money from the bank, and therefore have lower total interest repayments.

The only other common objection to land tax is that asset-rich but low-income home owners may be forced from their homes by their tax bill. However, it would be very simple for state governments to allow such people to defer their land tax payments, which would be indexed at a suitable rate and only fall due when the property next changed hands. Thus the land tax bill could be automatically deducted from the sale proceeds of the property when it was eventually sold.

As with any tax reform, a major change is daunting. However, the switch from stamp duties to land tax would be far less radical and disruptive than the move from sales taxes to the GST, and the economic efficiency benefits of moving to land taxes from stamp duties is far greater than those from the shift to a consumption tax.

In fact, land taxes are not only better than transfer duties, they are also far more efficient than consumption, investment or income taxes, because the amount of land available does not change in response to a tax change - there is a fixed amount, so only the value of the land changes.

The Henry Review cited an OECD report which found that a 1 per cent switch away from income taxes to a land tax would improve long-run economic growth per capita by 2.5 per cent.

That is not to say a modern government could or should raise all its revenue from land taxes, with equity considerations also dictating that other stores and manifestations of high income and wealth should be taxed.

However, there is a general consensus among economists that land tax should be a bigger part of the mix and stamp duties finally relegated to history, where they belong.

Michael Janda is the ABC's Online Business Reporter. View his full profile here.