One water catchment: one regional government

Any redesign of Australia's federal system must address the chronic under-provision of economic infrastructure, to which the preferred response of today's politicians is to blame some other level of government. A comprehensive solution requires two steps: first devise an effective mechanism for financing infrastructure; then work out the implications concerning the responsibilities and geographic boundaries of sub-national political units ("regions", "provinces", or whatever we want to call them).

Financing infrastructure: tapping benefits to cover cost

The market cannot value the benefit of infrastructure except through the price of access to the infrastructure; market value equals price of access. But the price of access has two components: the obvious one, namely the charges (fares, tolls, and so on) payable for actual use of the infrastructure; and the hidden one, namely the price of living or working in a location where the service provided by the infrastructure is available, as opposed to a location where it is not.

The value of a location is reflected in rents or prices of real estate in that location. More precisely, it is reflected in the rents or prices of sites, where a site is a piece of ground or airspace, including any attached rights to build on it or into it, but excluding any actual buildings. The value of a building in any location is limited by construction costs, whereas a site has a unique location, hence a locational value, even if no buildings yet occupy it.

So the "hidden" component of the price of access to infrastructure is the uplift in site values caused by provision of the infrastructure. Moreover, the benefit of the infrastructure to the public (as distinct from the provider, which is assumed to be government) is net of charges for actual use, and is therefore equal to the "hidden" component of the price of access. That is, the net benefit of infrastructure to the public is the total uplift in site values caused by the infrastructure.

Hence the economic cost/benefit ratio of an infrastructure project is simply the cost/uplift ratio. If the "cost" is understood as the cost to the provider, this is also net of charges for actual use, so that the cost/uplift ratio is the fraction of the uplift that must be recovered through the tax system in order to pay for the project. And if the project passes a cost-benefit test, this fraction is less than 100 per cent.

(Note: Obviously costs and benefits may have lump-sum and annualised components, while uplifts may be expressed in terms of sale prices or rents. For the purpose of the foregoing argument, all terms must be converted to the same basis, for example, present value or annuity.)

It follows that any infrastructure that passes an economic cost/benefit test can be financed by a tax collecting less than 100 per cent of the uplift in site values caused by the infrastructure. The rest of the uplift is a net windfall for the site owners.

Alternatively, if a certain fraction of every uplift is reclaimed through the tax system, infrastructure projects whose cost/benefit ratios are equal to that fraction will be self-funding, while projects with lower cost/benefit ratios will be more than self-funding, yielding net contributions to revenue which may be used for, for example, cuts in other taxes, or improvements in services other than "economic infrastructure".

Suitable revenue reforms

One obvious method of tapping uplifts in site values is a land value tax (LVT), i.e. a holding tax of so many percent per year of the market value of each site, payable by the owner. With such a tax in place, you cannot lose in consequence of any change in your tax assessment, because your tax bill does not increase unless your site value does, and your site value does not increase unless, in the judgment of the market, you are better off in spite of the tax implication.

Even the transition to an LVT regime can be managed so that there are no losers. The trick is to replace all recurrent property taxes - including rates, land tax, and special-purpose levies on property owners - with a single LVT including a per-site tax-free threshold, the threshold for each site being chosen so that the total recurrent tax payable in respect of each property is unchanged in the transition. Even so, the shifting of the tax burden off buildings and onto sites makes future revenue more sensitive to changes in site values, as desired for infrastructure purposes.

Another method of tapping uplifts is a title-transfer tax equal to some fraction of the increase in the site value since the last transfer. By definition, such a tax would be guaranteed not to cause or increase a loss on resale of a property. Again the transition to the new tax could be accomplished with no losers: the new tax would displace existing transfer taxes - including stamp duties and development levies - with the proviso that if the property was acquired under the old system, the seller shall have the option of paying tax as if the property had been sold and bought back on the last day of operation of that system.

Whether the new subnational governments replaced state and local governments or were simply enlarged local councils within the existing states, the new governments could take over, and then replace, the relevant existing property taxes. Indeed, if the new governments were to take a sufficient range of responsibilities, they might also need to take over some non-property taxes, which could then be phased out (thanks to those infrastructure projects that would be more than self-funding through their effects on site values).

Significance of water catchments

Three prominent types of infrastructure systems, namely water supply, drainage, and sewerage, are partly or fully dependent on gravity, so that watersheds tend to be system boundaries: each system and its effects on site values are confined to single water catchment. Furthermore, a bridge over a waterway connects one part of a catchment to another, and its effects on site values are (usually) similarly confined.

If the government responsible for such infrastructure does not have authority over the whole catchment, some of the related uplifts in site values may fall outside its taxing jurisdiction (the "spillover" problem), in which case the viability of the project may depend on co-operation with some other government(s). As the number of interested governments increases, the probability of agreement decreases. The opposite situation - one government serving more than one catchment - does not cause spillover, but makes government somewhat more distant from the people.

To avoid the spillover problem there should be, at most, one subnational government per catchment. This rule is flexible, not only because of the words "at most", but also because one "catchment" can usually be divided into sub-catchments; the rule implies that all regional boundaries should be watersheds, but not that all watersheds should be regional boundaries.

Example: the first Don Pedro Dam

In 1923, the farmers in the Irrigation Districts of Modesto and Turlock in California's Central Valley celebrated the completion of the original Don Pedro Dam, which was then the tallest gravity dam in the world (86 metres). Incredible as it may seem to modern Australian readers, this project did not come out of any state or federal pork barrel, but was conceived and funded entirely by the two Irrigation Districts. The up-front cost was met by selling bonds, which were repaid over time by land value taxes imposed within the districts by authority conferred on the districts through state legislation.

The main political obstacle to the project was the need to obtain agreement between the two districts, which were in the same catchment but on opposite sides of the Tuolumne river. The directors of Modesto, who allegedly stalled the negotiations with Turlock, had two of their number recalled by the voters, and were confronted by at least two public meetings of angry farmers telling them to get on with it. If more than two districts had been involved or the voters had been less well informed, the project might have failed.

Significance of urban areas

A new suburban transport route enhances site values in locations serviced by the new route, or by existing routes on which congestion is relieved by the new route. The effect on site values tends to be confined to a single metropolitan area. If the government responsible for a particular project does not have authority over the whole metropolitan area, some of the related uplifts in site values may fall outside its taxing jurisdiction, in which case the viability of the project may depend on co-operation with some other government or governments.

Hence it is desirable to have at most one jurisdiction per metropolitan area. Because of the tendency to build settlements on waterways, one jurisdiction per catchment usually implies at most one jurisdiction per metropolitan area; the exceptions tend to be large metropolitan areas resulting from conurbation or sprawl.

Example: London Underground

Don Riley, a successful property investor, has estimated that London's long-delayed Jubilee Line Extension, which cost the taxpayers £3.5 billion, increased site values within 1,000 yards of the ten new stations by a conservative £13 billion. If 27 per cent of that uplift in site values had been reclaimed through the tax system, leaving the other 73 per cent for the lucky property owners, the Jubilee Extension could have paid for itself without burdening any other taxpayers. Meanwhile in other parts of London, the long-promised Crossrail and Chelsea-Hackney projects remain stalled because of alleged financing difficulties - allegedly caused in part by the cost of the Jubilee extension!

If responsibility for a proposed suburban railway were divided among several local governments, so that no single government could manage the entire project or tax all the ensuing uplifts in site values, the need for agreement between governments could stall the project.

The continuing delays in the London Underground, however, have a more fundamental cause: the failure of the tax system to reclaim a sufficient percentage of uplifts in site values. If the "sufficient percentage" is again 27 per cent, the implication is that property owners near the Crossrail and Chelsea-Hackney routes, at no cost to other taxpayers, could have received 73 per cent of a multi-billion-pound windfall. Instead, they have received 100 per cent of nothing. Such are the penalties for opposing site value taxation.

Conclusion 

Any infrastructure project that is economically justifiable can be funded out of the uplift in site values caused by the project. If the tax system fails to reclaim a sufficient fraction of such uplifts, projects that are more than capable of paying for themselves will be stalled because of an alleged lack of funding. Even under a well designed tax system, a desirable project may be stalled if some of the related uplifts in site values fall outside the jurisdiction of the government financing the project. But the latter risk can be minimised by having (at most) one subnational government in any water catchment or metropolitan area. These facts should guide all reforms of jurisdictional boundaries, from local council amalgamations to wholesale redesign of the federal system.