Home affairs: options for reforming property taxation

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Executive summary

Over the past 18 months research for the Intergenerational Commission has illustrated that, in a range of areas, the assumption that each generation will do better than the one before it is under pressure.

This paper is one of a series that moves beyond the diagnosis of these problems to consider what action is needed to address generational living standards challenges. The Intergenerational Commission’s final report later this year will recommend a specific suite of reforms across a broad range of policy areas. In this paper, we present policy options that incorporate ideas from leading thinkers, history and abroad, and set out the strengths and weaknesses of different policy approaches. Our focus here is residential property tax reform.

How we tax residential property matters for a range of reasons that are core to the Intergenerational Commission’s diagnosis of a growing generational living standards divide. Property taxation affects the levels of revenue available for public services; people’s disposable incomes; the wealth distribution itself; and the efficiency and volatility of the housing market. A commonly held view, however, is that the main property taxes we have – council tax and stamp duty – leave a huge amount of room for improvement.

Britain’s fiscal challenge in the decades ahead necessitates a focus on our dysfunctional property taxes

Despite years of spending cuts and recent signs that the government’s current budget may reach balance next year, Britain faces a fiscal challenge in the coming decades. Our ageing population means a requirement for additional public spending on health and care in particular. In just over a decade (by 2030) the additional annual spending requirement to maintain current levels of state provision amounts to £20 billion per year, rising to £60 billion in 2040. Relying on the usual income and consumption taxes that fall mainly on working-age populations to meet these costs appears much more challenging than it may have in the past, given younger cohorts are experiencing little or no living standards progress on their predecessors at the same age.

In searching for ways to spread the burden, an obvious avenue is Britain’s growing stock of wealth that is increasingly concentrated among members of older generations who will be the main beneficiaries of additional public spending. Wealth is particularly ripe for attention when we consider that while it has grown 2.5 times faster than the economy since 1980, wealth-related taxes have remained flat. Three-quarters of wealth taxation of households in the UK was made up by council tax and residential stamp duty in 2016, totalling £30.4 billion and £8.6 billion respectively. This paper therefore focuses on these taxes in Great Britain and on council tax in particular, given that the failure of wealth taxation to keep up with wealth is in a large part down to council tax falling far short of what most people would think of as a functioning property tax.

Council tax has come to look very like the poll tax it replaced

There are a number of principles on which to base property taxation, including matching the treatment of other income or consumption through income tax and VAT, better taxing wealth windfalls, or taxing land because its supply is relatively inelastic and its value derived from community inputs. All of these theoretical approaches imply that property taxes should be clearly linked to property value. However, council tax is only weakly linked to property values and has failed to capture changes in these over time. This approach is highly regressive. For example, someone living in a property worth £100,000 in 2015-16 had around five times the effective tax rate (council tax relative to property value) of someone living in a property worth £1 million. This regressivity derives from the following features of council tax:

  • The existence of wide bands in which council tax bills in a given area are exactly the same: Council tax is levied equally within eight bands (nine in Wales). This means that the lowest-value properties in each band have a significantly higher effective tax rate than the highest-value properties in each band. For example, the lowest-value tenth of properties in band A in the North East of England were worth £65,000 or less in 2015-16 while the highest-value tenth were worth at least double at £130,000 or more. Given they faced the same tax bill, this resulted in effective council tax rates at least twice as high at the bottom of the band as at the top.
  • The small differences in council tax rates between bands: Specifically, regressivity results from the fact that the council tax differences between bands (which are fixed at the national level) have throughout its existence been much smaller than the differences in property values themselves. For example, in 2015-16 typical (median) gross council tax bills in Great Britain were 3.3 times as high in band H as in band A (£2,595 and £775 respectively). By contrast, typical property values were 6.8 times as high (£750,000 and £110,000 respectively).
  • The fact that council tax is based on severely out-of-date property values: Council tax bands are based on property values that are 27 years out of date (15 years in Wales). Because the value of some properties has grown at a very different rate to others over this period, inequities between individual properties have emerged, and particularly between regions that have experienced different house price trends. For example, rapid house price growth in London means that only 36 per cent of properties in the capital worth above the national average today were placed in the top four council tax bands in 1991. By contrast, in the North West 67 per cent of above-national-average properties are in the four most expensive council tax bands.
  • Regional variation in council tax rates: Very different property values in different areas of the country mean that higher-value areas (in which a greater share of properties are in top bands) can set council tax lower in order to fund a given level of services. Combined with the regressive nature of the band structure and out-of-date valuations, this drives much lower effective council tax rates in the South of England than elsewhere. For example, in 2015-16 the typical net council tax bill (i.e. accounting for council tax reduction schemes) was around 10 per cent higher in London than in the North East, however typical property values were 220 per cent higher.

Together, these features of council tax result in regional and distributional inequities on average. But their combined effects drive even more severe injustices when individual households are compared. For example, a search of property comparison websites shows that a three-bedroom flat for sale for £2.1 million in South London faces a council tax bill of £700 per year. In contrast, another three-bedroom flat for sale just one mile away at less than one-fifth of the price (£400,000) faces a council tax bill of £1,160 per year, 66 per cent higher.

The regressive nature of council tax is in stark contrast to the progressive structure of income tax: average net council tax is only 2.7 times higher for the top 10 per cent of properties than the bottom 10 per cent, whereas average income tax is 45 times higher in the top income decile than the bottom one. In fact, apart from things like TV licences, there’s no other large UK tax that replicates council tax’s peculiar ‘flatness’. It appears that despite replacing the unpopular ‘poll tax’ (community charge) council tax has come to look increasingly like it.

Britain’s property taxes are highest for the young and drive inefficient housing outcomes – doubly disadvantaging young adults

From a generational perspective, it is important to note that the regressivity of the council tax system falls hardest on the young and especially on the current generation of young adults, who are more likely than their predecessors to live in the lowest (most regressive) council tax bands. 85 per cent of households in their 20s in Great Britain lived in the bottom three council tax bands in 2015-16, compared to 79 per cent 19 years earlier. The result is that as a proportion of property value – and even more so as a proportion of property wealth given low home ownership among younger cohorts – council tax has become most generous to older households.

Not only does council tax fail to capture the large housing wealth gains of recent decades, it also actively makes the housing market less efficient. Second homes and empty properties are, on the whole, still subsidised; consumption of large houses is under-taxed relative to consumption of smaller ones; and property is under-taxed relative to other investments. These and other features have boosted house prices and led to inefficient stock allocation, both of which have affected younger generations in particular in terms of entry into home ownership and the fact they have less space than predecessors.

Our other tax on property, as a transaction tax, adds to these housing market inefficiencies. Residential stamp duty discourages families from downsizing or moving areas and has little to commend it economically. But stamp duty does raise substantial revenue and is – unlike council tax – both related to current property values and very progressive. The main impact of any cuts to stamp duty – if done in isolation – would be large windfall gains for wealthy home owners in London and the South East.

Changes to council tax within the existing band structure could make it somewhat less regressive

Some reform is possible within the framework of the existing council tax system, and many approaches have been suggested in recent years. In Wales, a small additional band was added for a minority of high-value properties; and Labour and the Liberal Democrats have proposed a ‘mansion tax’ for the most expensive homes. We find that these policies, if applied across England and Great Britain respectively, would raise relatively little revenue (up to just over £1 billion), but their impact would be focused on the top-fifth of the income distribution, London and the South East.

In Scotland, council tax in the top four bands has recently increased. We find that this approach would raise £1.1 billion if replicated in England and Wales. Going further, proposals along the lines of those made by Labour MP Chris Williamson – involving much bigger council tax increases in top bands including a doubling at the very top – could raise £6.6 billion in additional revenues across Britain, but would inevitably increase taxes for a large number of people. All of these changes would have the largest impact on the top parts of the income distribution and on older households.

However, these and other similar reforms that have been proposed within the existing council tax band structure would still leave a regressive tax relative to property values, crude banding, and an unchanging 1991 valuation (2003 in Wales). And, other than the ‘Williamson’ model, few would make a significant contribution to our fiscal challenge. More fundamental reform is likely needed.

Abolishing council tax and replacing it with a proportional or progressive property tax would more fully address its problems

Property taxation reform is often seen as particularly politically challenging, and history provides caution regarding reforms to local government financing. But, equally, council tax is little-loved and bears many of the features of the unpopular poll tax it replaced. And there is a strong consensus among those who have made proposals for replacing council tax about what a replacement should look like. In addition, there are lots of international examples of better-functioning property taxes to draw on. Finally, while the challenge of frequent valuations has long been considered a barrier to reform, new technology and mechanisms for feedback from taxpayers used in other countries mean that revaluation is now nothing like the challenge it might have been in the 20th century. We should therefore not be overly pessimistic about the potential for a better recurrent property tax system.

To illustrate the potential for the replacement of council tax, we model five example policies (though many more variations are of course possible). Across these options, we assume no single person discounts, no favourable treatment of second and empty homes, and no student exemptions, with the suggestion that some in these groups could instead be supported via other means. All these options would raise additional revenues that could be used to meet growing health and care costs, to reduce stamp duty and to better support property taxpayers on low incomes via the benefits system:

  • A proportional tax of 0.5 per cent of capital value, boosting annual revenues in Great Britain in 2015-16 by £1.6 billion compared to council tax.
  • A slightly higher proportional tax of 0.7 per cent, boosting revenues by £12.7 billion.
  • A 1 per cent tax rate with a £100,000 tax-free allowance per property, which in 2015-16 would have meant no tax for the bottom 14 per cent of properties nationally and would make effective tax rates progressive above this. This would boost revenue by £8.6 billion.
  • A 1 per cent tax rate with a regionally-specific tax-free allowance per property. To account for large geographic variation in house prices, it would be possible to set allowances so as to make the least valuable 10 per cent of properties in each region tax free. These allowances range (in 2015-16) from £72,000 in the North East to £160,000 in the South East and £240,000 in London. This system would raise £3.8 billion in additional revenues.
  • Tax bands of 1 per cent and 2 per cent, with a regionally-specific tax-free allowance per property. To illustrate the potential for multiple tax rates – which exist in some countries – we add to the above option a higher rate of 2 per cent on marginal property values above £500,000. This system would raise £8.4 billion.

In all except the option of a proportional tax of 0.7 per cent (which raises the most money), the large majority of households would be better off as a result of these reforms, and average disposable incomes would be boosted for the bottom half of the income distribution. Outside the South of England, average incomes would rise in each region (except under the 0.7 per cent proportional tax) and renters and those in their 20s experience either average income gains or much smaller losses than others. Focusing on the final example that includes both regionally-specific allowances and 1 per cent and 2 per cent tax bands, the majority of people in each region apart from London would be better off, and even in London 38 per cent of households would have lower tax bills. The large majority of each age group would also be better off under this option in comparison to the current council tax system, including 73 per cent of 20-29 year olds and 63 per cent of 60-69 year olds. However, among the roughly one-third of households nationally (9 million) that would pay more tax, average losses would be relatively substantial at just under £2,000 per year, and for some the losses would be larger still.

It is important to note that our modelling doesn’t account for any ‘dynamic’ effects, however. Changes in property taxes can be expected to be partially ‘capitalised’ through one-off changes in house prices. The implication is that revenues raised and the impacts on annual disposable incomes (both positive and negative) would be somewhat smaller than modelled here, but this analysis nonetheless provides a useful guide as to the scale and incidence of alternative options.

A reformed recurrent property tax might allow for reductions in residential stamp duty. This is expected to raise £7.4 billion next year (excluding higher charges on additional properties). Clearly then, the options above would allow very significant cuts in the form of threshold increases, rate cuts or both. In the long run such stamp duty cuts would partially offset tax increases for owners of valuable properties from the move to a proportional or progressive property tax.

Beyond rates and allowances, property taxation in Britain could be improved in a range of other ways

Any major reform to property taxation raises a number of questions, not least in terms of how a new system would be brought in. A period of transition would seem advisable and necessary, but is not something this analysis considers in detail.

An oft-discussed idea is whether taxing land values would be a better alternative to taxing property values. One challenge would be that it is likely to be practically more difficult to regularly value land than residential property. Beyond this practicality and the separate-but-related question of how vacant land is taxed, this decision appears rather less consequential than others regarding a replacement for council tax, given that property values and land values are generally closely related. The proportionality of tax, regular revaluation and the considerations below are more fundamental.

The degree of local variation in property taxation is critical to its incidence and – arguably – to local democracy. This is wrapped up with the local government finance settlement process and the level of redistribution between authorities, which would need to increase under a more progressive residential property tax system. This paper does not set out in detail how these elements of the system should be structured, but implicit in our illustrative policies is the idea that national government would play the lead role in setting the rate of property tax, perhaps with some regional differences. On top of this, tacking back closer to the existing system and matching the Irish model, some capacity for local variation could be maintained. For example, local authorities could have the ability to vary the tax rate within set limits, and bear responsibility for managing the increased or reduced revenues resulting from these decisions.

Some changes are worth considering under both the existing council tax system and any replacement of it. A particularly important consideration is whether the direct burden of tax should move from occupiers to property owners. This is the more common international approach, and the potential administrative savings (both for individuals and councils) could be significant. Owners change less frequently than tenants and social and private landlords could streamline the payment of taxes that are currently made separately by millions of people and which result in remarkable volumes of arrears and court action.

The importance of council tax reduction for those on low incomes should also be stressed. Although making property tax less regressive would somewhat reduce the need for such support, means-tested help can play a crucial role in making property tax progressive by income as well as by property value. Support, however, was cut significantly for poorer working-age families in England when the system was localised in 2013, and minimum payments – where some tax is due regardless of income – are now common. Any reform should seek to at least return to earlier levels of support – which would reduce additional revenues under the final policy alternative described above by around £1 billion – and could go further still. Reform could also provide the opportunity to reconsider the costs and inefficiencies of keeping the administration of council tax reduction schemes separate from Universal Credit.

Finally, there is a strong case for allowing deferral of payment or the ability to pay in kind in the form of an equity share of property. Alongside enhanced support via the benefits system, this would protect ‘cash-poor, asset-rich’ older households, and could even be a means of making equity release more accessible than it is at present.

A far better property tax, stamp duty cuts and additional revenues for health and care are possible

Clearly there are a wide range of choices within any reforms to council tax and stamp duty, and policy needs may vary across the nations of Great Britain. Indeed, as it stands Scotland and Wales have the power to make changes within the existing system that they could make more use of.

Focusing on an alternative system nationally, we note that an approach including regional variation in allowances and a progressive structure would raise an estimated £7.4 billion a year nationally even after allowing a reversal of cuts to council tax reduction. Some of these revenues could be used to halve residential stamp duty rates for primary residences at a cost of £3.2 billion, leaving over £4 billion for health and care costs or other spending priorities.

Even while raising taxes overall, and before considering the impacts of lower stamp duty, a replacement recurrent property tax could easily leave a large majority of voters better off. In addition, all those not able to own their own home could be taken out of the system entirely, and where necessary taxes could be deferred until death leaving many more with no annual bill. A tax based on timely valuations would dampen changes in property prices, and provide an improved link between tax revenues and new public investments that boost property values. A fairer property tax system – intergenerationally, distributionally and regionally – that also makes the housing market more efficient and less volatile is an achievable end.

Summary of key policy options for consideration

Some progress can be made via tweaks to the existing council tax structure, but in the longer term the abolition and replacement of council tax with a proportional or progressive system would more fully address its many problems. From least to most ambitious, the approaches worth considering include:

  • Increasing council tax on the very highest-value properties, for example by replicating reforms in Wales where an additional band was added, or by introducing a ‘mansion tax’ on properties worth over £2 million.
  • Changing the rates of council tax charged in certain bands, for example by increasing council or removing single person discounts in the top bands, potentially offset by lower rates in the bottom bands.
  • Abolishing council tax and replacing it with a property tax related to up-to-date values based on regular revaluations. This new tax could be either proportional to value or progressive via tax-free allowances and differential rates, and potentially allow for some regional variation.

As part of any of these changes, policy makers should consider:

  • Ending discounts for second homes, empty properties and single-adult households, and helping low-income groups through other means.
  • Using some of the additional revenues from the reform or replacement of council tax to reduce stamp duty.

In addition, there are a number of key questions that must be addressed in the process of reforming property taxation. With a view to making reforms as fair and feasible as possible, changes could include:

  • Allowing local authorities to vary the main property tax rate, within limits.
  • Basing a new tax on property rather than land values.
  • Basing a new tax on capital rather than rental values.
  • Moving property taxation to owners rather than occupiers.
  • Increasing the generosity and efficiency of income-based means-tested support for property taxes.
  • Making property tax payment more convenient by facilitating payment direct through PAYE and other income sources.
  • Allowing deferral of payment, or payment in the form of an equity stake.