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).