A Plague on Most of Our Houses

Imagine a tax where the owner of Ford Fiesta pays proportionately four times more per pound value than the owner of a Rolls-Royce, where second and third cars pay half the rate of first cars and where there is a huge discount if the owner lives in Kensington and Chelsea compared with Liverpool.

This is, in effect, how the current council tax works in Britain. A more rational system of local property taxation could bring improvements to a range of problems, including not just regional congestion, unemployment differentials and inequalities but also earnings inflation, monetary policy and the single currency.

The government takes seriously the environmental impact of taxation in other spheres. Petrol tax (or indeed VAT on motor vehicles) has obvious benefits. The potential of a property tax as a congestion tax should be considered by the Royal Commission on Environmental Pollution.

The current system is perverse: the houses greediest for space, in the most expensive locations and belonging to those with more than one home attract the lowest tax rates. But it is small homes that are most highly taxed, despite the trend towards smaller families.

Thus, within a local authority where someone in a £40,000 house pays council tax of £500, a rate of 1.25 per cent, the tax rate drops to 1.07 per cent at £70,000, 0.47 per cent at 320k, 0.15 per cent at £1m. This is using (often hypothetical) 1991 valuations, increasingly remote from the market experience of valuers. Second or third houses attract only half the tax rate on first houses.

A more sensible tax structure would reduce the demand for greenfield sites in the south-east where projections of housing demand so alarm those concerned with protecting the environment.

Curbing property price rises in the overheated south-east would, in turn, help reduce the upward pressure on earnings inflation and spending. At present, the Bank of England faces these pressures alone, driving up interest rates and sterling, and thus widening the north-south divide.

In new research*, we find a strong connection between the real exchange rate and the unemployment rate in regions with above average employment in manufacturing and mining. For example, a 10 per cent rise in the real exchange rate eventually widens the unemployment rate differential between the West Midlands and the national average by around one percentage point.

We suggest the following package of council tax reforms. First, properties should be revalued every two years or indexed to local house price indices with a full revaluation every five years. This has become much easier with the information revolution that has made Land Registry house price data by post codes available on the internet. Regular revaluations make the reformed tax into a valuable "automatic stabiliser": in other words, cooling overheated parts of the economy without any conscious action by policymakers.

Second, tax rates should be proportional to market value above a lower limit of, say, £20,000. This would encourage the choice of smaller homes and reduce the unemployment trap for those on council tax benefit. (If the system of "house price bands" were retained, many more bands would be needed at higher values).

Third, local authorities should be required to set the tax rate between certain limits, say 0.6 per cent and 1 per cent, to reduce regional inequalities. Rate support grants to local authorities need to be adjusted in line with the property tax base.

The main objection to property taxes is that property owners do not always have commensurate cash incomes. Therefore, pensioners in particular should have the option of allowing property tax debt to build up, to be settled at the time of sale of the property or from the estate. Efficient financial markets would readily allow local authorities to convert these claims into cash.

Finally, for democratic acceptability, the reform should ensure that many less well-off households find that tax payments fall while, at the other end of the income scale, part of the higher tax revenue generated could be used to reduce the top rate of income tax.

Our proposal has the scope to broaden the tax base because council tax, as a fraction of national income, yields only about two-thirds as much as the old domestic rates. Its genesis as "daughter" of the disastrous poll tax should make council tax far from immune to change.

Reforms of this type are likely to prove essential if Britain is to retain any realistic chance of joining the euro in the foreseeable future. They are unquestionably desirable on grounds of efficiency and equity, the environment, the development of the regions and the avoidance of booms and busts.

(*) 'Earnings, Unemployment and Housing: Evidence from a panel of British Regions', CEPR Discussion Paper 2404, March 2000. An earlier version was published as Nuffield College Economics Discussion Paper 1999-W7, 1999.
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