Property Taxes: There’s a Right Way, and There’s a Wrong Way

Caught this yesterday (excerpt):

Selangor, Penang tax hike woes

ONE part of Pakatan Harapan's manifesto covers cost of living and taxes, and points fingers at federal government policy.

If they are serious about reducing the cost of living and taxes, they should first look at Selangor and Penang.

On Dec 26, the Selangor Mentri Besar's Office scrambled to respond to my assertion that property-related taxes are the main cause of increase in cost of living in Selangor.

Datuk Seri Azmin Ali refused to accept my assertion and blamed Putrajaya and the goods and services tax (GST) for the increase….

…There was a significant increase in cost of living between 2008 and 2011, years before the implementation of GST.

Moreover, the initiatives rolled out in 2016 by the state government were focused on rural residents. The MB's Office said several hundred thousand owners of kampung houses were given exemption on assessments.

But what about urban residents in the cities and towns where over 80% of Selangoreans reside?

The residents in apartments and urban dwellings have had to pay higher quit rent and assessment taxes since 2008?

This is where most of the increase in cost of living happens.

Most Selangor residents live in cities and towns and have been significantly affected by the rapid rise in property prices and rental because of the state government's policy.

I’m not going to play politics here. Property related taxes have increased across most states, and in my opinion probably a bigger factor in the increased cost of living than anything else. We can all argue over who is at fault, but ultimately, nothing much will change unless fundamental reforms are carried out.

The real heart of the matter here is state finances, particularly in the raising of revenue. Something like 70%-80% of state revenue comes from property taxes of one sort or another. I actually don’t mind if this was raised via quit rent or assessments, which directly taxes home owners. These are, in economic terms, efficient taxes – those who consume public services are also the ones who pay for them.

Unfortunately, most of the increase in revenue comes from a different source – land conversion premiums and development charges. Unlike direct taxes like quit rent and assessment, these are hopelessly inefficient.

Here’s why: premiums and charges are paid by land developers. Since these add on to the cost of housing, the price of new homes must rise (holding profit margins constant). But the way the housing markets work is that changes in transacted prices form benchmarks for existing housing, since valuations depend on market prices. So the additions to housing supply have the effect of raising the value of ALL housing, and not just for the new units. This results in a windfall for existing home owners, for which they are NOT taxed (except minimally via marginally higher quit rent and assessment on the higher value of their property).

As a result, on the one hand, the burden of taxation falls primarily on new home owners while existing home owners get a free ride. On the other hand, the state government raises revenue, but only on the value of new housing and not the total increase in wealth that results. Effectively, there’s a wealth transfer from new home owners – and by extension, all future generations of Malaysians who have to live with higher prices – to existing home owners. In other words, raising revenue this way contributes to an increase in wealth inequality.

Note that I’m not arguing here for a unilateral cut in taxation. States have a legitimate need to raise revenue to pay for local public services. The almost total reliance on property taxes however means that state governments have a vested interest in keeping property prices going up, with all that implies in terms of raising wealth inequality. Or, as the immortal Sir Humphrey Appleby put it, “If you must do this damn silly thing, don’t do it in this damn silly way.”

One way to fix this is to shift the burden of taxation from indirect to direct – reduce coversion premiums and development charges while raising the more efficient quit rent and assessment to compensate. Not only will this be fairer but it should also increase housing supply, which is another contributory factor behind higher prices. Given the political fallout such a move will cause, this will probably happen when pigs fly. Another alternative is a land value tax, which I talked about here. I’m not too hopeful about its adoption either.

Ultimately, what’s really required here is a total revamp of state finances. In other countries, sub-national authorities have the right to levy their own income and sales taxes. India’s GST implementation last year, for example, was more about streamlining existing the GST regimes run by each state, more than a national imposition of a new tax. In the United States, most states levy their own income taxes on top of sales taxes. One possible idea here is a revenue sharing formula of federal government GST proceeds with states, which may or may not require an increase in the rate. Or alternatively, states can levy their own VAT on top of GST.

But state finance reform would require rethinking and renegotiating the relationship between citizen and state government, and between federal and state governments. The likelihood of that happening? I think I’ll sit by the window to wait for the pigs.