THE CAPITALISATION OF BUSINESS RATES: AN EMPIRICAL STUDY OF TAX INCIDENCE IN SIX LONDON BOROUGHS Nigel Mehdi Submitted for the Degree of PhD London School of Economics & Political Science 2003 1 UMI Number: U615607 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI U615607 Published by ProQuest LLC 2014. Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code. ProQuest LLC 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106-1346 SJbZlOl Z9 d SZZIH l Abstract THE CAPITALISATION OF BUSINESS RATES: AN EMPIRICAL STUDY OF TAX INCIDENCE IN SIX LONDON BOROUGHS ABSTRACT This work is concerned with tax shifting and capitalisation of recurrent taxes on immovable property, known as business rates in the United Kingdom and payable by occupiers of business property. The empirical research seeks to identify to what extent business rates are transferred into rents and thus capitalised. If the tax is capitalised, then freehold owners will bear the burden of the tax. If not, the tax may be shifted in some other way, for example, reducing the occupiers’ profits or increasing the prices charged to customers. The extent of any tax shifting will be affected by the value of any benefits received by the occupier in exchange for the tax paid. Previous studies of business property tax incidence in the UK have met with mixed results and problems of poor and inadequate data have hampered research efforts. In this work particular emphasis has been given to detailed data collection, which has been carried out in the field at the property unit level and, by using this meticulous approach, it was possible to control for data issues that have confounded earlier studies. The empirical research is based on data collected for business properties in six London boroughs. Matched pair data has been collected for industrial, retail and office property. The study takes advantage of a one-off historic situation that existed before the introduction of the Uniform Business Rate in 1990. At that time, large differences in the property tax burden existed between many local authority areas and these differentials had been present for several years. The chief hypothesis predicts that property values will gradually adjust so that total occupation costs between matched pairs of properties will be equalised over time. The results of the empirical study confirm the hypothesis and show that total occupation costs do tend to be equalised in the long term. The results justify the painstaking approach to data collection that was an important part of the overall research design. 2 Contents THE CAPITALISATION OF BUSINESS RATES: AN EMPIRICAL STUDY OF TAX INCIDENCE IN SIX LONDON BOROUGHS Title Page 1 Abstract 2 Table of Contents 3 Full Table of Contents 4 List of Tables 10 List of Figures 14 Acknowledgments 16 Chapter 1 Background and Introduction 17 Chapter 2 The Determination of Rental Value 32 Chapter 3 The Economics of Property Taxation 64 Chapter 4 A Review of the Existing Empirical Studies 89 Chapter 5 Business Rates: The UK Property Tax 116 Chapter 6 Methodology and Data Requirements 140 Chapter 7 Data: Validation, Matching and Collection 157 Chapter 8 Data: Analysis and Results 188 Chapter 9 Conclusions and Discussion 223 Appendices 247 Bibliography 314 3 Contents FULL CONTENTS List of Tables 10 List of Figures 14 Acknowledgments 16 Chapter 1 Background and Introduction 17 1.1 Introduction 18 1.2 Tax Classification 19 1.3 The Importance of Business Property 20 1.4 The Significance of Business Rates 21 1.5 Some Possible Impacts of Business Rates 23 1.6 Difficulties with Data 25 1.7 Aims of This Research 26 1.8 Time Frame of the Empirical Work 27 1.9 Structure of the Thesis 29 Chapter 2 The Determination of Rental Value 32 2.1 Introduction 33 2.2 Definitions 33 2.3 Land - Separate Factor or Species of Capital? 34 2.4 Early Economic Theories of Land Value 39 2.5 Contemporary Models of Urban Land Rent 41 2.6 The Theory of Rent as a Residual 42 2.6.1 Elementary Rent Model 42 2.6.2 A Look at the Assumptions 45 2.6.3 Property Market Perfection and Efficiency 47 2.6.4 Developing the Theory 49 2.6.5 The Impact of the UK Institutional Lease 49 2.6.6 The Impact of a Rise in Costs Relative to Revenue 53 2.7 Rental Value - A Demand and Supply Analysis 54 2.7.1 Individual Property Level 54 2.7.2 Aggregate Property Level 55 4 Contents 2.8 Rental Value and Property Type 57 2.8.1 Industrial 57 2.8.2 Retail 59 2.8.3 Offices 60 2.9 The Determination of Freehold Capital Values 61 2.10 Conclusions 62 Chapter 3 The Economics of Property Taxation 64 3.1 Introduction 65 3.2 International Perspective 65 3.3 Principles of Taxation 67 3.3.1 Excess Burden 67 3.3.2 Administrative and Compliance Costs 68 3.3.3 Is the Tax‘Fair’? 69 3.3.4 Benefit Taxes 69 3.3.5 The Ability to Pay Principle 70 3.3.6 Horizontal Equity 72 3.4 Tax Incidence 72 3.4.1 Formal Incidence 74 3.4.2 Economic Incidence 74 3.5 A Model of Tax Incidence 76 3.6 Tax Capitalisation 81 3.7 Modern Neoclassical Incidence Theory 82 3.8 Alternative Incidence Frameworks 86 3.9 Conclusions 87 Chapter 4 A Review of the Existing Empirical Studies 89 4.1 Introduction 90 4.2 Developments in Empirical Methodologies 91 4.2.1 The Tiebout-Oates Model 91 4.3 Classification of Studies 94 4.4 Studies of Business Property Impacts 96 5 Contents 4.5 Aggregate Level Business Property Studies 97 4.5.1 Evidence of Short-Term Impacts 98 4.5.2 Evidence of Impacts on Employment 100 4.5.3 Evidence from Other Aggregate Studies 101 4.6 Micro Level Business Property Studies 102 4.6.1 US Evidence 103 4.6.2 UK Evidence 104 4.6.3 Bennett and Fearnhough 105 4.6.4 Sibley 105 4.6.5 Crosby and Keogh 107 4.6.6 Bond, Denny, Hall and McCluskey 109 4.7 Conclusions 113 Chapter 5 Business Rates: The UK Property Tax 116 5.1 Introduction 117 5.2 Local Government Organisation 118 5.2.1 A History of Reorganisation 118 5.2.2 Revenue and Sources of Finance 120 5.3 Background to the 1990 Changes 122 5.4 The Great Rate Debate 123 5.5 Rate Divergence and Central Control 125 5.5.1 Central Government Grants 126 5.5.2 Changing Rate Burdens 1973-1988 126 5.6 Political Dimensions 129 5.7 Six London Boroughs 130 5.7.1 London Borough of Enfield 136 5.7.2 London Borough of Haringey 136 5.7.3 London Borough of Barnet 137 5.7.4 London Borough of Brent 137 5.7.5 Westminster City Council 138 5.7.6 London Borough of Camden 138 5.8 Conclusions 139 6 Contents Chapter 6 Methodology and Data Requirements 140 6.1 Introduction 141 6.2 Defining the Research Question 141 6.3 Telephone Survey of Prospective Occupiers 145 6.4 Benefits to the Taxpayer 146 6.5 Research Design 148 6.6 Matched Pairs 152 6.7 Data Requirements 154 6.8 Conclusions 156 Chapter 7 Data: Validation, Matching and Collection 157 7.1 Introduction 158 7.2 Validating the Data Assumptions 158 7.2.1 Rate Burden & Rental Value - The 158 Principal Variables 7.2.2 Checking the Underlying Accuracy of 160 Rateable Values 7.2.3 Monitoring the General Level of Values 162 in the Rating List 7.2.4 Selection of Local Authorities with Separate 164 Valuation Offices 7.2.5 Verification that the Valuation Methods 165 Adopted were Acceptable 7.3 Chief Observations 168 7.4 The Problem of Size 168 7.5 Matching of Pairs 171 7.5.1 Primary Analysis Matching Criteria 172 7.5.2 Secondary Analysis Matching Criteria 178 7.6 Data Collection 180 7.6.1 Industrial Data-sets 181 7.6.2 Retail Data-sets 183 7.6.3 Office Data-sets 185 7.7 Conclusions 187 7 Contents Chapter 8 Data: Analysis and Results 188 8.1 Introduction 189 8.2 Summary of Data Analysis Procedures 189 8.3 Pilot Study - Triangulating the Results 192 8.3.1 Pilot Study Data-set 192 8.3.2 Regression Analysis of Pilot Data-set 194 8.4 Primary Analysis - Cross-Sectional Tests 196 8.4.1 Test 1: Pre-Divergence Equivalence in 1973 197 8.4.2 Test 2: Post-Divergence Impact in 1988 199 8.4.3 Test 3: Equalisation of Total Occupation 200 Costs in 1988 8.4.4 Primary Analysis of 1985 Pilot Study Subset 201 8.5 Primary Industrial Property Analysis 206 8.6 Primary Retail Property Analysis 209 8.7 Primary Office Property Analysis 212 8.8 Secondary Analysis - Rental Growth Test 215 8.8.1 Test 4: Differential Rental Growth 216 8.8.2 Secondary Analysis of 1985 Pilot Study Subset 217 8.8.3 Differential Rental Growth -1988-98 218 8.9 Conclusions 222 Chapter 9 Conclusions and Discussion 223 9.1 Introduction 224 9.2 Research Problem and Methodolgy Used 224 9.3 Summary and Discussion of Results 228 9.4 Of Politics and Policy 237 9.5 Future Research 241 9.6 Conclusions 244 Appendix 1 Business Rates: The Legal Framework 247 A1.1 Introduction 248 A1.2 Historical Background 248 A1.3 The Rating System Before 1990 249 A1.3.1 Tax Base 249 A1.3.2 Tax Rate 251 A1.3.3 Rateable Occupation 251 A1.3.4 Rating Authorities 252 A1.4 Local Government Finance after 1990 253 8 Contents Appendix 2 Rental Value and the Hypothetical Tenancy 256 A2.1 Introduction 257 A2.2 Rental Value versus Price 257 A2.3 Analysis of Comparables 258 N2A Hypothetical Tenancy 259 A2.5 Valuation Dates 263 Appendix 3 Gearing Effect of Cost Increases 265 Appendix 4 Empirical Evidence for Residential Property 267 A4.1 Introduction 268 A4.2