FIRE Sector: Finance, Insurance and Real Estate

Louis Post: Outlines of Louis F. Post's Lectures, with Illustrative Notes and Charts (1894) — Appendix: FAQ

Q33. Would not the full single tax destroy the basis of all credit — land values?
A. The full single tax — one hundred per cent of annual ground rent — would wipe out land values, which are but the capitalization of rent. But land values are not the basis of credit. Merchants do not prefer mortgages on land as security for commercial debts, unless they hope to get the ownership of the land through foreclosure. The true basis of every man's credit, from the consumer at the cross-roads store to the great retail merchant at the factory or the jobbing house, is honesty, opportunity, and ability. He who will pay his debts if he can, and has an opportunity to earn enough to pay them with, and is able to make good use of the opportunity, needs no land values to offer as a basis for commercial credit. He has the ideal basis of all credit. And this basis of credit every man could have if the single tax were in operation.

Q49. Would the single tax abolish interest?
A. I do not think so. Interest properly understood is a form of wages, and so far from abolishing it, the single tax, which would tend to increase all forms of wages, would tend to increase interest. But monopoly profits are often confounded with interest, and by force of association have given to interest a bad name; these would be minimized if not wholly abolished by the single tax. It is impossible to answer this question intelligibly to everyone who asks it, without requiring him to be specific; for it is seldom that two persons agree as to what they mean by interest. The Western farmer thinks of the high rate that he pays, partly for risk, partly from his ignorance of the modus operandi of banking, and partly because legitimate banking facilities are scarce in his Community; the Wall Street operator thinks of the premiums that he pays for currency in times of stress to tide him over from day to day; others think of "interest" on government bonds, and others of dividends of companies with valuable land rights. None of these payments are really interest, and the single tax would tend to rid society of them. But that advantage which the workmen enjoy whose implements and materials are already gathered, over those who have yet to devote time to gathering implements and materials, an advantage which is expressed in money and as interest upon capital, will not, I should think, be abolished by anything that man can do. The value of such an advantage is part of the wages of the labor that creates it. ... read the book

Nic Tideman: Basic Tenets of the Incentive Taxation Philosophy

Making Housing Affordable

The implementation of our ideas would have a dramatic effect in making housing more affordable. The principal reason why housing costs have risen so much is that the price of land has risen enormously. Some increase in the price of access to land is a natural accompaniment of an increasing population.

But the very great increases of recent years, which have made it nearly impossible for young families to afford houses of their own, have additional causes. The implementation of our ideas would bring down the price of access to land in three ways.

First, much land is held off the market by speculators who may wait generations do decide to develop it. The introduction of a fee for holding land, whether used or not, equal to the rental value of the land, will induce speculators to either develop this land themselves or turn it over to someone who will.
Second, an important cause of higher prices for access to land by those who wish to build low-cost housing is zoning restrictions. These restrictions are introduced by political factions that already have their houses and do not mind if housing becomes scarcer. It just raises the market value of their homes. But if a rise in land values were accompanied by rises in the fees that existing residents had to pay for the use of the land on which their houses sit, they would have an incentive to do what they could to make land plentiful rather than scarce, and zoning restrictions could be expected to diminish.
Third, a person who wishes to own a house must borrow money to cover the price of buying the title to the land on which the house sits as well as the cost of the house itself. If the use of land required the payment of a fee equal to the rental value of land, so that the selling price of land titles became virtually zero, then the amount of money that a family would have to borrow to purchase a house would fall. ... Read the whole article

Michael Hudson: The Lies of the Land: How and why land gets undervalued

Turning land-value gains into capital gains

YOU MAY THINK the largest category of assets in this countrly is industrial plant and machinery. In fact the US Federal Reserve Board's annual balance sheet shows real estate to be the economy's largest asset, two-thirds of America's wealth and more than 60 percent of that in land, depending on the assessment method.

Most capital gains are land-value gains. The big players do not want their profits in rent, which is taxed as ordinary income, but in capital gains, taxed at a lower rate. To benefit as much as possible from today's real estate bubble of fast rising land values they pledge a property's rent income to pay interest on the debt for as much property as they can buy with as little of their own money as possible. After paying off the mortgage lender they sell the property and get to keep the "capital gain".

This price appreciation is actually a "land gain", that is, it's not from providing start-up capital for new enterprises, but from sitting on a rising asset already in place, the land. Its value rises because neighbourhoods are upgraded, mortgage money is ample, and rezoning is favorable from farmland on the outskirts of cities to gentrification of the core to create high-income residential developments. The potential capital gain can be huge. That's why developers are willing to pay their mortgage lenders so much of their rent income, often all of it.

Of course, investing most surplus income and wealth in land has been going on ever since antiquity, and also pledging one's land for debt ("mortgaging the homestead") that often led to its forfeiture to creditors or to forced sale under distress conditions. Today borrowing against land is a path to getting rich -- before the land bubble bursts. As economies have grown richer, most of their surplus is still being spent acquiring real property, both for prestige and because its flow of rental income grows as society's prosperity grows. That's why lenders find real estate to be the collateral of choice.

Most new entries into the Forbes or Fortune lists of the richest men consist of real estate billionaires, or individuals coming from the fuels and minerals industries or natural monopolies. Those who have not inherited family fortunes have gained their wealth by borrowing money to buy assets that have soared in value. Land may not be a factor of production, but it enables its owners to assert claims of ownership and obligation, i.e., rentier income in the forms of rent and interest. ...

Hiding the free lunch
BAUDELAIRE OBSERVED that the devil wins at the point where he convinces humanity that he does not exist. The Financial, Insurance and Real Estate (FIRE) sectors seem to have adopted a kindred philosophy that what is not quantified and reported will be invisible to the tax collector, leaving more to be pledged for mortgage credit and paid out as interest. It appears to have worked. To academic theorists as well., breathlessly focused on their own particular hypothetical world, the magnitude of land rent and land-price gains has become invisible. But not to investors. They are out to pick a property whose location value increases faster rate than the interest charges, and they want to stay away from earnings on man-made capital -- like improvements. That's earned income, not the "free lunch" they get from land value increases.

Chicago School economists insist that no free lunch exists. But when one begins to look beneath the surface of national income statistics and the national balance sheet of assets and liabilities, one can see that modern economies are all about obtaining a free lunch. However, to make this free ride go all the faster, it helps if the rest of the world does not see that anyone is getting the proverbial something for nothing - what classical economists called unearned income, most characteristically in the form of land rent. You start by using a method of appraising that undervalues the real income producer, land. Here's how it's done.

PROPERTY IS APPRAISED in two ways. Both start by estimating its market value. The land-residual approach subtracts the value of buildings from this overall value, designating the remainder as the value of land. ... The building-residual approach starts by valuing the land, and treats the difference as representing the building's value. ...

Everyone recognized the absurdity of calculations depicting all the corporate land in America as having a negative value in 1993. Suppose somebody same to you and said: "I'll give you $4 billion, but there's a catch. Along with the $4 billion in cash, you will have to accept ownership of all the land owned by every non-financial corporation in the United States." Most people no doubt would see that they were being given assets much more valuable than $4 billion, and would jump at the offer. The Fed's statistic would be dismissed as a comic exercise showing how economists tend to lapse into otherworldly speculation. But in this case the motive is all too worldly. Looking beneath the surface, one finds the not-so-invisible hand of self-interest by the real estate industry and its financial backers.

To give the Fed economists their due, they evidently came to the conclusion that their statistics were fatally flawed. The September 1997 balance sheet estimates made a start along new lines by including a calculation reflecting the original (historical) cost of buildings. This gave land a positive value. But nationwide totals were no longer compiled. No longer was there a line labeled "land," nor does the Fed publish a residual number for market value less the historical cost (or even the replacement cost) of buildings. Instead of making better land estimates, the Fed has dropped what had become a political and statistical hot potato. 1994 is the last year for which it has estimated economy-wide land and building values.

This leaves in limbo the macro-economists and business analysts whose business is to explain the finance, insurance and real estate (FIRE) sector's dominant role in the economy. According to the land-residual appraisal technique, high-rise buildings seem to have the lowest land values. Real estate interests argue that this is realistic, because at least in New York City the higher a building is, the more of a subsidy its developers need, given the economics of space involved for elevators, surrounding air space and so forth. The land itself is assigned a negative value as a statistically balancing residual reflecting the difference between the building's high construction costs and its lower market value. ...

In view of real estate's dominant role in the economy, it is ironic that no attempt has been made to provide better statistics. My research has shown that the Fed's methodology undervalues land by as much as $4.5 trillion. As matters stood in 1994, for instance, the Fed estimated the U.S. economy to hold some $20 trillion in real assets (excluding human capital, for which no official statistics are published). The land's value was calculated to be $4.4 trillion, and building values $9 trillion. My estimates based on historical values suggests that land rather than buildings represents two thirds of the nation's overall real estate value -- $9 trillion, leaving building values at just half this amount. ...

The commercial loft building in which I lived rose in price from $40,000 in 1986 to $120,000 in 1980 and $4,000,000 in 2000. This sharp increase cannot be explainable by rising building costs. The building itself steadily deteriorated. All that increased was its site value. Today, of course, that property a block from the World Trade Center has fallen back in price, just as many new buyers had renovated their structures. The site's value changed without any significant reference to construction costs. One must infer that it is the site that determines the property's value.

In a thriving real estate market appraisers typically use a rule of thumb in allocating resale prices as between land and buildings to reflect their pre-existing proportions. Buildings typically are assumed to account for between 40 percent and 60 percent of the property's value. As a result, building values are estimated to grow along with a property's overall sales value. This appraisal practice is made to appear plausible as the pace of asset-price inflation tends to go hand in hand with rising construction costs, and hence in the theoretical replacement cost of buildings.

As noted, the anomaly occurs when real estate prices fall. Real estate prices are volatile, while construction costs rarely dip more than slightly, if at all. When real estate prices turn down, they often plunge below the reproduction cost of buildings. Hence, the residual ("land") rises and falls much more sharply than do building replacement costs (which are estimated as rising at a fairly steady pace) and overall property values. ...

Real estate industry's priorities

REAL ESTATE LOBBIES recognize that what is not seen is less likely to be taxed. What is not quantified for public policy-makers to see clearly may avoid taxes, leaving property owners with a larger after-tax return. They prefer land-residual's capital gains statistics at the national level, even as individual investors seek site-value gains at the local level.

This explains the seeming irony that investors in an industry dealing primarily with the development of land sites have campaigned to minimize the statistical treatment of land. Relegating land to merely secondary status enables the real estate industry to depict its "capital" gains as resulting from cost inflation and hence the reproduction costs of buildings -- whose value is allowed to be depreciated and re-depreciated at rising values over time. The free lunch of land-price gains is unseen as attention is diverted from the real estate bubble and land-price inflation to building costs. These fiscal considerations help to explain why it has been so hard to get Washington to produce national land value statistics. ...

Whether the gains come from selling the property or from borrowing more money against it, the essential phenomenon is the rapid growth in asset values and real estate's uniquely favored tax treatment. That's why investors choose real estate instead of bonds or stocks, and much of the strategy underlying corporate takeovers has followed the strategies they developed over the past half century.

Nationwide the capital-gains dimension needs to be incorporated into the rental revenue statistics to measure real estate's total returns. This sector's nearly complete success in escaping the tax collector has placed an enormous tax burden on everyone else. Read the whole article

Mason Gaffney: Who Owns Southern California?

1. HOLDINGS BY ALIENS ... Non-resident aliens own about 75% of the "major" buildings in the L.A. CBD west of Broadway ...
2. AMERICANS FROM OTHER STATES ... A second kind of holder is the out-of-state American, individual or corporate.
3. CALIFORNIANS Many of our largest landholders also live in California. This is partly because the lands are here, but moreso because certain places in California are good places to live. One of the advantages of receiving property as opposed to labor income is it lets one choose his residence. California ranks after New York in the number of rich Americans (using Forbes' list) who reside here.

Also included here are California-based corporations. A corporation's "base" refers simply to the site of its headquarters: its shareholders are scattered around the world, and the major shareholders, who exercise control, are effectively screened behind layers of trusts and financial institutions, so they are impossible to identify with certainty.
4. INSTITUTIONS
Institutions acquire land for their operations and then it tends to stick to them for various reasons. It is tax free, for one, so long as they retain it (and do not use it commercially). They are not subject to corporate raids. Thus there is no mechanism whereby the current opportunity cost of land is felt by management. It never appears in their budgets; they never need compete for or justify it. College Boards are not accountable to any public body, a precedent set by Marshall's U.S. Supreme Court in Dartmouth College v. Woodward, 1819.

Karl Williams: Social Justice In Australia: ADVANCED KIT - Part 2

BANKING AND INTEREST

"The seed ye sow, another reaps;
The wealth ye find, another keeps;
The robe ye weave, another wears;
The arms ye forge, another bears."

- Percy Shelley, (1792 - 1822), English poet

It's both fascinating and disappointing to see how excessive rates of interest are today so generally and meekly accepted by the public. Only until a few centuries ago usury, which is the old word for the practice of lending money at exorbitant rates of interest, was one of the long-standing worst sins of Christendom. Islam widely outlaws interest and excessive profit margins of any kind even today.

In many respects, the basis for this prohibition is as valid now as it was then. It is this: a significant proportion of the interest demanded is immoral in that it is unearned and therefore undeserved. Certainly the lender needs to be reimbursed to take account of administrative costs, the effect of inflation, and the element of risk involved, but what has the lender done to deserve a rate of return above and beyond this?

LAND, AGAIN
However varied the factors determining the rate of interest may be, the land issue plays an overriding role. Essentially, the rate of return available from land props up the rate of return available to moneylenders (i.e. the profitability of holding land supports excessive interest rates).

There are two distinct yields available from land.

The first, its natural agricultural fertility, is of little importance in the modern world.
The second, its locational value, remains as important as ever and is produced by the activities of society, but ends up in private hands under land monopoly capitalism.

The new and extremely important point is that, in the long run, the rate of return available to investors in land is the most lucrative of all, effectively acting as a de facto benchmark as the highest rate of return, allowing for risk. Indeed, during the period 1960 - 2000 in Australia, land values increased on average 5.8% pa, whereas household disposable income only increased 1.96% pa. This gets us back to the very nature of land. The fact that it is limited in supply and is an unavoidable necessity for human existence means that rising populations make land increasingly scarce and valuable, thus bidding up its price. The other powerful, sure boost to land values arises from the fact that the locational value of land is increased by society, particularly through the provision of infrastructure. And history has shown that, wherever an industry has boomed through enterprise and inventiveness, land prices soar in its vicinity. For a recent example of this ageless phenomenon, look at the recent spectacular rises in land prices in Silicon Valley. So, with land being a sure-fire investment winner, why would anyone lend for a rate less than that available from investing in land? The corollary here is that, as we collect LVT and cut out the opportunities to profit from owning land, interest rates must then fall. The banking issue is not simple and deserves its own section which follows, where the privilege of banks to create credit is specifically dealt with.

BANKS AND THE MONEY SUPPLY
There is another great and rarely-seen source of privilege milking us - the privilege of private banks "creating" money out of credit. Essentially, through the so-called multiplier effect, banks can lend out far more money than they have as deposits, all the while charging interest as if the basis for their lending was based on something as real as the banknotes in your wallet. Furthermore, banks have claimed a special status and importance such that, when their irresponsible and risky practice of lending money they don't possess gets them in trouble, governments (read: ordinary mugs like you and I!) often have to come to the rescue and bail them out.

FOR PEOPLE, NOT PRIVILEGE!
The "privilege of inventing money", like the privilege to own land, needs to become a source of wealth for society instead of being, as it is now, a source of power for a few at the expense of everyone else. The fraud consists:

In inventing money disguised as loans, and therefore burdened with a debt that has no reason to be
In inventing money not at the time and for the purpose needed, but at the whim of banks and their clients, i.e. completely divorced from the real economy

The story of how the banking system acquired the privilege of defrauding the public can be read elsewhere. Here it is important to note that high interest rates are indissolubly linked to the land monopoly. When land, instead of being widely distributed, is grabbed by a powerful minority, investing in land becomes the most profitable type of investment, with returns guaranteed with increasing population and public infrastructure growing around it.

With such high returns to land, no one therefore would deposit money in a bank at an interest lower than what land can offer. But banks have to make money, so they have to lend at an interest higher than that at which they borrow. Result: two economies come into being: one reserved to banks and money manipulators earning returns while creating no wealth, and the other, the real economy of production which is either starved of necessary liquidity or forced to pay usurious interest.

A COMMON RESOURCE
The solution is to consider money as what it is, i.e. an artificial common resource. As such, it should be issued by the public monetary authority debt-free, when the natural growth of the economy dictates. How can we determine if the real wealth of an economy has grown sufficiently in order for the government to issue more money? By the value of land, again! Instead of basing our money supply on reserves of gold and the whims of bankers, money should be based on the real wealth of our nation, and nothing reflects our real wealth better than the value of our land and natural resources. Build infrastructure and our land values increase. Clean up the environment, reduce crime, and generally make our nation a better place to live and our land values increase. But do something dumb like get involved in a war and our land values decrease. Land and natural resources should be the true indicator of our real underlying wealth instead of paper profits, funny money and ingots of gold. Some geonomists have been increasing proposing such a radical monetary reform which would abolish the outrageous privileges that banks possess. ... Read the entire article

Jeff Smith and Kris Nelson: Giving Life to the Property Tax Shift (PTS)

John Muir is right. "Tug on any one thing and find it connected to everything else in the universe." Tug on the property tax and find it connected to urban slums, farmland loss, political favoritism, and unearned equity with disrupted neighborhood tenure. Echoing Thoreau, the more familiar reforms have failed to address this many-headed hydra at its root. To think that the root could be chopped by a mere shift in the property tax base -- from buildings to land -- must seem like the epitome of unfounded faith. Yet the evidence shows that state and local tax activists do have a powerful, if subtle, tool at their disposal. The "stick" spurring efficient use of land is a higher tax rate upon land, up to even the site's full annual value. The "carrot" rewarding efficient use of land is a lower or zero tax rate upon improvements. ...

First-time home buyers make out like bandits. They'd pay a higher land dues to their community but lower total taxes to government, a lower price to the seller, and a lower mortgage to the lender. Is it fair that one group should benefit so prodigiously? Yes. In many US cities, renters now outnumber owners. High rates of tenancy, as shown in Goldschmidt's 1940s study of the Central California towns Arvin and Dinuba, engender apathy and indifference, which are bad for democracy, community involvement, street safety, and environmental protection. The sooner young families can become homeowners, the better off all members of society will be. ...

While beneficiaries have a hard time envisioning their gains, losers have an easy time calculating their losses. The big loser is not homeowners; while losing equity, they keep all earnings untaxed. Nor is it realtors, while losing their few big sales, they gain many smaller ones. Nor is it developers; while paying higher infrastructure fees, they'd pay less for prime land. No, the big losers would be banks who'd have to readjust to pre-World War II levels of lending rates. As they probably won't want to give up their unearned income, advocates of PTS will need to use moral arguments (as in the struggle against slavery) to gain public support and use practical arguments to pry realtors, developers, service businesses, and small businesses aside, thereby isolating lenders.

A big problem needs a big solution which in turn needs a matching shift of our prevailing paradigm. Geonomics -- advocating that we share the social value of sites and natural resources and untax earnings -- does just that. Read the whole article

Jeff Smith: What the Left Must Do: Share the Surplus

Buying a land title – the granddaddy of all privileges – typically requires a mortgage, which disguises rent as “interest”. Pierre Joseph Proudhon (1809-1865), French journalist/anarchist, noted: "As long as land monopoly is maintained, the few can take possession of what Nature free of charge has granted to everyone, and usury will penetrate the whole society, and we will have banks, which instead of being servants for the exchange of goods will become powerful extorters." He called this one; today’s banks do bleed the economy. Read the whole article

Jeff Smith: Leaking Economic Value of Communities

Wearing pajamas outdoors in the winter, one wouldn’t expect to retain body heat. Yet, people do try to sustain community while hemorrhaging its commonwealth. Losing it, residents must work more than necessary.

When residents import food and energy, they deprive others in the community of income. Yet, the loss pales when compared to paying mortgages and [income] taxes. A recent study of Oakland, CA found torrents of dollars pumped out of town headed for the treasuries of distant capitols and the bank vaults of distant lenders.

While mortgages and interest elevate an elite elsewhere, they keep debtors on a treadmill at home. To those anxious over every next payment, how appealing is an economy no longer expanding its girth? In addition, what’s their debt for? Credit? The total savings of all members of a community should suffice. Local bank "used to" be the norm. ...

Forgoing natural values makes sustaining community tough. Where communities improve infrastructure - pave a bike path, clear an amphitheater, recycle gray water, bury their transmission lines - they attract people. Where people do community well—vote, volunteer, host block parties, join neighborhood watch, organize open-air markets—they draw people. People moving in push up the cost to live there. Rising values attract speculators who further inflate site values.

Inflated land values require heavier mortgages and are afforded by high-income people paying high taxes. Expanding infrastructure to accommodate growth forces local government to raise taxes or borrow. Many people who made their community attractive can no longer afford to live there.

Were a community to collect its own values, it could not only afford its public services; most places would also end up with a surplus that they could disburse as a local dividend (a la Alaska’s oil dividend). The author of Steady-State Economics, Herman Daly, noted this possibility. Receiving this "rent share," people could live where they love, love where they live.

Community, where we live, and economy, how we live, cannot be separated. As long as communities leak economic value, they cannot sustain themselves in a steady-state, like the skinny guy with a tapeworm wondering why he’s always hungry. By reclaiming land values, a community plugs its leaks so residents can sustain the lives of nature and neighborhood ... Read the whole article

Peter Barnes: Capitalism 3.0 — Chapter 7: Universal Birthrights (pages 101-116)

Dividends from Common Assets

A cushion of reliable income is a wonderful thing. It can be saved for rainy days or used to pursue happiness on sunny days. It can encourage people to take risks, care for friends and relatives, or volunteer for community service. For low-income families, it can pay for basic necessities.

Conversely, the absence of reliable income is a terrible thing. It heightens anxiety and fear. It diminishes our ability to cope with crises and transitions. It traps many families on the knife’s edge of poverty, and makes it harder for the poor to rise.

So why don’t we, as Monopoly does, pay everyone some regular income — not through redistribution of income, but through predistribution of common property? One state — Alaska — already does this. As noted earlier, the Alaska Permanent Fund uses revenue from state oil leases to invest in stocks, bonds, and similar assets, and from those investments pays yearly dividends to every resident. Alaska’s model can be extended to any state or nation, whether or not they have oil. We could, for instance, have an American Permanent Fund that pays equal dividends to long-term residents of all 50 states. The reason is, we jointly own many valuable assets.

Recall our discussion about common property trusts. These trusts could crank down pollution and earn money from selling ever-scarcer pollution permits. The scarcer the permits get, the higher their prices would go. Less pollution would equal more revenue. Over time, trillions of dollars could flow into an American Permanent Fund.

What could we do with that common income? In Alaska the deal with oil revenue is 75 percent to government and 25 percent to citizens. For an American Permanent Fund, I’d favor a 50/50 split, because paying dividends to citizens is so important. Also, when scarce ecosystems are priced above zero, the cost of living will go up and people will need compensation; this wasn’t, and isn’t, the case in Alaska. I’d also favor earmarking the government’s dollars for specific public goods, rather than tossing them into the general treasury. This not only ensures identifiable public benefits; it also creates constituencies who’ll defend the revenue sharing system.

Waste absorption isn’t the only common resource an American Permanent Fund could tap. Consider also, the substantial contribution society makes to stock market values. As noted earlier, private corporations can inflate their value dramatically by selling shares on a regulated stock exchange. The extra value derives from the enlarged market of investors who can now buy the corporation’s shares. Given a total stock market valuation of about $15 trillion, this socially created liquidity premium is worth roughly $5 trillion.

At the moment, this $5 trillion gift flows mostly to the 5 percent of the population that own more than half the private wealth. But if we wanted to, we could spread it around. We could do that by charging corporations for using the public trading system, just as investment bankers do. (For those of you who haven’t been involved in a public stock offering, investment bankers are like fancy doormen to a free palace. While the public charges almost nothing to use the capital markets, investment bankers exact hefty fees.)

The public’s fee could be in cash or stock. Let’s say we required publicly traded companies to deposit 1 percent of their shares each year in the American Permanent Fund for ten years — reaching a total of 10 percent of their shares. This would be our price not just for using a regulated stock exchange, but also for all the other privileges (limited liability, perpetual life, copyrights and patents, and so on) that we currently bestow on private corporations for free.

In due time, the American Permanent Fund would have a diversified portfolio worth several trillion dollars. Like its Alaskan counterpart, it would pay equal yearly dividends to everyone. As the stock market rose and fell, so would everyone’s dividend checks. A rising tide would lift all boats. America would truly be an “ownership society.” ... read the whole chapter

Jeff Smith: What To Do About the Real Estate Bubble

What’s bubbling, and until when?

Sellers are happy. So are developers and speculators. Real estate has gone all bubbly, and that bubble has gone ballistic. What goes up, however, must soon do something else. ...

Actually, it’s not housing whose price has entered the stratosphere. Buildings age – get older, more worn out. What’s getting more valuable is the land, the location – whether it has a building on it or not. Buildings you can make more of, but land you can not, especially locations along the coasts or on the good side of town. None of that would matter if you could ever get buildings to hover around in the air. Meanwhile however, speculators are happy.

... What’s seemingly good for landowners is not necessarily good for the economy. As people spend more on land, something nobody produced, they spend less on output, things people do produce. As producers get less money spent on their products, eventually they take the hint and produce less. "Produce less" is another way of spelling recession.

Plus, more expensive land means heavier borrowing to buy it. More debt means more inflation and less stability. When producers cut back, borrowers have a much harder time paying back their debts. As people go bankrupt, they drag others down with them. A collapsing house of cards is another way of spelling depression.

Preventing bubbles?
If land values didn’t get inflated, of course they would not have to get deflated.Call it mutual compensation for deprivation from part of our common natural heritage. While in rhythmic systems, prices must rise and fall, but they need not boom then bust; they could climb then glide. What would temper economies, preventing bubbles? Rather than let a few lucky owners collect land values, neighbors would have to recover land values for themselves. Nobody made land, and no lone owner made its value; the presence of society in general did that. Plus, for excluding everyone else from their sites, owners owe everyone else, as each one of us owes everyone for excluding them.

To recover land value, government could either transform the property tax into a land tax or replace it and other taxes with land dues or land use fees or an annual deed fee. ...

To pay the land dues, owners use their land efficiently; owners who had been speculating get busy and develop. No longer allowed to tax anything that moves, local governments, too, which presently let acres of abandoned urban land and buildings lie fallow, get busy, too, and make sure to get those acres into the hands of ambitious owners who’ll pay land dues. More locations put to use and more buildings put up increases supply, which dampens price.

Better still, as government recovers land rent, that leaves owners with less land rent to capitalize into land price. Hence buyers need not borrow so much. ...

Land would still rise in value. With every discovery of a nearby natural resource. With the opening of every new bridge. With every techno-advance, as silicon wafers did for Silicon Valley. With every jump in income and drop in crime, land value rises. But no longer into a bubble. Because every rise would find its way – via land dues and rent dividends – into everyone’s pockets. ...

If the 18-year average holds for this cycle, then real estate still has a few more years of sucking all the investments and purchasing power out of the rest of the economy. Land is still able to soak it all up, and lenders are still willing to pump more in. So despite the premature panic (markets almost never do what everybody says they’re going to do), Mankiw’s 2007 would be the earliest that the current bubble would burst, and 2008 is just as likely.

Then land prices will fall for a few years. Since the run-up was steep, the drop will be, too – after correcting for inflation, maybe as much as 50%. Which will be an enormous relief for the economy – just what the doctor ordered. With land affordable again, a new cycle can get under way. Whether the new one will be boom and bust or climb and glide is up to us, whether we’re willing to practice geonomics, to forego taxes and subsidies in favor of land dues and a Citizens Dividend.

While I don’t mind the current gambling, I do mind the widening of the cavernous gulf between haves and have-nots, and I boil over while workweek grows more onerous, and just seethe watching vacant lots and abandoned buildings push development out from urban cores to sprawl on suburban farmland. To reverse that, let’s let go of the individual owner’s hold on land rent and share Earth’s worth equitably among us all. We’ll all be glad we did. ... Read the whole article

Michael Hudson and Kris Feder: Real Estate and the Capital Gains Debate

Capital gains taxation has been a divisive issue in Congress at least since the debates surrounding the Tax Reform Act of 1986, which, aiming to eliminate tax loopholes and shelters and preferences, repealed preferentially low tax rates for long-term gains.1 To bring effective capital gains tax rates back down again was President Bush’s “top priority in tax policy.“2 In 1989, Senate Democrats blocked a determined drive to reduce effective tax rates on the part of Bush, Republican Senators Packwood, Dole and others, and a few Democratic allies.3 The administration argued that the tax cuts would stimulate economic growth and induce asset sales, thereby actually increasing federal tax revenues; Congressional Democrats countered that the plan benefited mainly the wealthy, and that tax revenues would in fact decline.4 The Joint Committee on Taxation projected that budget shortfalls beginning in 1991 would sum to about $24 billion by 1994 -- and that most of the direct benefits would go to individuals with over $200,000 in taxable income. House Speaker Thomas S. Foley said that a third of the savings would be enjoyed by those with gross incomes over one million dollars. ...

What is missing from the discussion is a sense of proportion as to how capital gains are made. Data that is available from the Department of Commerce, the IRS, and the Federal Reserve Board indicate that roughly two thirds of the economy's capital gains are taken, not in the stock market -- much less in new offerings -- but in real estate. ...

This policy brief seeks to elucidate the role of real estate in the capital gains issue, indicating the quantitative orders of magnitude involved.. We offer two main observations.

First, generous capital consumption allowances (CCAs) greatly magnify the proportion of real estate income taken as taxable capital gains. Capital gains accrue not only on newly constructed buildings, of course, but also on land and old buildings being sold and resold. Our tax code allows for properties to be re-depreciated by their new owners after a sale or swap, permitting real estate investors to recapture principal again and again on the same structure. When CCAs have been excessive relative to true economic depreciation, as they were during the 1980s, capital gains have been commensurately larger than the actual increase in property prices. As Charts la and lb illustrate, capital consumption allowances in real estate dwarf those in other industries.
Second, very little of real estate cash flow is taxable as ordinary income, so the capital gains tax is currently the only major federal levy paid by the real estate industry. CCAs and tax-deductible mortgage interest payments combine to exempt most of real estate cash flow from the income tax. This encourages debt pyramiding as it throws the burden of public finance onto other taxpayers.

A central conclusion of our study is that better statistics on asset values and capital gains are needed -- or, more to the point, a better accounting format. The economic effects of a capital gains tax depend upon how the gains are made. The present GNP/NIPA format fails to differentiate between wealth and overhead; between value from production and value from obligation. In particular, theory and measurement should distinguish real estate from other sources of capital gains -- aid, within the category of real estate, distinguish land from built improvements. Markets for immovable structures and for land have distinctive inherent features20 and are shaped by distinctive institutional constraints.

Our second major conclusion is that, at least until re-depreciation of second-hand buildings is disallowed, a capital gains tax cut would be unlikely to stimulate much new investment and employment from its largest beneficiary, the real estate industry. Depreciation allowances and mortgage interest absorb so much of the ongoing cash flow as to leave little taxable income. Mortgage interest payments, which now consume the lion’s share of cash flow, are tax-deductible, while CCAs offset much of what remains of rental income. On an industry-wide basis, in fact, NIPA statistics reveal that depreciation offsets more than the total reported income. As Charts 2a, 2b, and 2c illustrate, real estate corporations and partnerships have recently reported net losses year after year. ...

The result is that real estate corporations pay minimal income taxes -- some $1.3 billion in 1988, just one percent of the $137 billion paid by corporate America as a whole.2122 These three symbiotically linked sectors thus were left with only capital gains taxes to pay on their cash flow.
Comparable figures are not available on non-corporate income tax liability, but the FIRE sector (finance, insurance, and real estate) reported negative income of $3.4 billion in 1988, out of a total $267 billion of non-farm proprietors’ income.

21 US Bureau of Economic Analysis, NIPA Table 6.18.
22 NIPA Table 6.12.

The central point for capital gains tax policy is that taxable capital gains in real estate consist of more than just the increase in land and building prices. They represent the widening margin of sales price over the property’s depreciated value. The tax accountant’s book-value gains result from charging off capital consumption allowances as a tax credit against cash flow. The more generous are the capital consumption write-offs for real estate, the more rapidly a property’s book value is written down. The fiction of fast write-off is eventually “caught” as a capital gain when the real estate is either sold or refinanced.

Excessive depreciation allowances thus convert ordinary income into capital gains. Moreover, capital gains are the only point at which most real estate income is taxed
To abolish the capital gains tax would annul the entire accumulated income tax liability which real estate owners have converted into a capital gains obligation. The income written off over the years as over-depreciation would not be caught at all. The economy's largest industry would have its income rendered tax-free. ...

Depreciation and Capital Gains

Much of the statistical measurement problem derives from the fact that capital gains in real estate differ from those in other industries. While all investors presumably would prefer to take their income in non-taxable forms and to defer whatever tax obligation is due, the tax benefits to the real estate industry have no analog in manufacturing, agriculture, power generation, transportation, wholesale and retail trade, or other services. Corporations in these sectors pay taxes on their net incomes. Out of their after-tax earnings they then pay dividends, on which stockholders in turn must pay income tax. By contrast, little or none of the rental cash flow received by real estate investors is taxable, because generous capital consumption allowances are treated as costs and deducted from the net income reported to the IRS.

The effect of calculating capital gains for real estate on the basis of depreciated book values may be illustrated by the following example. A building bought in 1985 has probably been fully written off today, thanks to the generous CCAs enacted by the 1981 tax code that remained in place through 1986. For a parcel bought in 1985 for $100 million and sold today for $110 million, the recorded gain is not merely the 10 percent increase in market price, but the entire value of the building, perhaps $65 million based on the real estate industry’s average land-to-building assessment ratios. ...

Landlords already deduct from earnings as normal business expenses their maintenance and repair expenditures, undertaken to counteract the wear and tear of buildings. A rule of thumb in the real estate industry is that such expenditures typically consume about ten percent of rental revenue. More importantly, although nearly all land gains are made fully taxable, there is little reason to assume that physical deterioration should be compensated by a special allowance to enable the landlord to recover his capital investment within a given number of years. ...

Depreciation rules are not the only reason why the real estate sector declares little taxable income. Out of their gross rental income, landlords pay state and local property taxes, a tiny modicum of income tax, and interest on their mortgage debt. A large proportion of cash flow is turned over to lenders as mortgage payments. Since the early 1970s, interest paid by the real estate industry has been much larger than the figures reported for net rental income. As Charts 3a, 3b, 3c, and 3d illustrate, real estate investors and homeowners have become the financial sector’s prime customers. According to the Federal Reserve Board, 1994 mortgage debt of $4.3 trillion represented some 46 percent of the economy's $9.3 trillion private nonfinancial debt, and a third of the total $12.8 trillion U.S. debt.27 NIPA statistics indicate that about 70 percent of loans to business borrowers currently are made to the real estate sector, making it the major absorber of savings and payer of interest. ...

Most cash flow now ends up neither with developers nor with the tax authorities, but as interest paid to banks, insurance companies and other mortgage lenders. In fact, mortgage interest now absorbs seven percent of national income, up from just one percent in the late 1940s. ...

One effect of favorable depreciation and capital gains tax treatment is to spur debt pyramiding for the real estate industry. The tax structure provides a distortionary incentive for real estate holders to borrow excessively, converting rental income into a nontaxable mortgage interest cost while waiting for capital gains to accrue. This, alongside financial deregulation of the nation’s S&Ls, was a major factor in the over-building spree of the 80's. ...

Reported capital gains in real estate were understated as a result of exclusions. On the other hand, much direct investment included the cost of land, commercial buildings, and plant and equipment. Taking this into account, we estimate that roughly 70 percent of the capital gains calculated by the IRS for 1985 probably represent real estate. Even this estimate may understate the role of land and real estate. In 1985, anticipating the planned 1986 tax reform which would raise the capital gains tax rate from 20 to 28 percent, many investors sold their securities that had registered the largest advances. Some 40 percent of the capital gains reaped by selling these stocks probably represented real estate gains. A major spur to the LBO movement driving up the stock market was an awareness that real estate gains were not being reflected in book values and share prices;36 as land prices leapt upward-funded in part by looser regulatory restrictions on S&L lending against land -- raiders bought publicly traded companies and sold off their assets, including real estate, to pay off their junk-bond backers. In effect, not only were rental income and profits being converted into a flow of interest payments; so also were capital gains. ...

When statistics are lacking, it often is because some interest groups are benefiting in ways they prefer not to see quantified and publicized. If land assessments lag behind actual increases in market value, for instance, land speculators, as well as homeowners, will pay less than their legislated tax share. Also -- and of direct relevance to our thesis -- the failure to distinguish statistics on land values and other real estate gains from non-real-estate capital gains in industry and finance makes it easier for the real estate industry to get its own taxes reduced along with industries in which capital gains tax cuts do indeed tend to spur productivity. ...

The LBO movement epitomizes the real estate industry‘s strategy, applying the developer’s traditional debt-pyramiding techniques to the buying and selling of manufacturing companies. Raiders emulated developers who borrowed money to buy or construct buildings and make related capital improvements, agreeing to pay interest to their mortgage bankers or other lenders, putting down as little equity of their own as possible. Having set things in motion, the landlord uses the rental income to carry the interest, principal, taxes and maintenance charges while he waits for a capital gain to accrue. The idea is to amortize the loan as slowly as possible so as to minimize annual carrying charges, while paying them out of the CCA.

For many decades securities analysts have pored over corporate balance sheets in search of undervalued real estate whose book value does not reflect gains in market value. From the merger and acquisition movement of the 1960s through the takeover wave of the 1980s, the raider’s strategy has been to borrow money to buy the target company’s stock, and then sell off its real estate and other assets to repay the creditors, hoping that something will be left for himself after settling the debts incurred in the process. For the bankers and other creditors, LBOs were a way to put savings to work earning higher rates of interest. The ensuing junk bond commotion pushed interest rates over 15 percent for high-risk securities, whose major risk was that quick capital gains and the cash flow available from re-depreciating properties would not cover the interest payments to the institutional investors rounded up by Drexel Burnham and the other investment bankers who underwrote the takeovers.

The object of building, like buying and selling companies, is thus by no means only to earn rental income. Most cash flow is pledged to lenders as debt service in any case. In a world of income taxation subject to loopholes, sophisticated investors aim not so much to make profits as to reap capital gains -not only in the stock and bond markets, but also in real estate, other natural resources, and the monopoly privileges that have come to underlie much of the pricing of securities today.

As developers borrow money to finance real estate purchases, lenders, for their part, use the real estate sector as a market to absorb and service the economy's mounting stock of savings, applying most of the rental cash flow to pay interest to savers. The end result is that most total returns are taken by the wealthiest ten percent responsible for nearly all the economy's net saving. Viewing US economic statistics from this perspective shows that not to calculate capital gains in the national income accounts alongside directly “earned” income helps foster the illusion that more equality exists among Americans than actually is the case. The fact is that earned income is more equally distributed than unearned gains.

This distinction between real estate (and by extension, other natural resource industries and monopolies) and the rest of the economy helps explain the familiar economic rule that inequalities of wealth tend historically to exceed inequalities of income. The reason is that the wealthiest layers of society control even more of the economy's assets -- and the capital gains on these assets -- than they do its income. They also obtain a larger proportion of cash flow and other non-taxable income than they do of taxable “earned” income.

This phenomenon has long been known, but not well explained. Edward Wolff has shown that wealth is more unequally distributed than income, but he leaves capital gains out of account in explaining how the American economy has grown more top-heavy.45 It is unequal wealth that is primarily responsible for generating inequality of incomes. The more the returns to wealth can avoid taxation by being categorized as capital gains, the faster this inequality will polarize society.

43 Wolff (1995), p. 27. “The top one percent of wealth holders has typically held in excess of one-quarter of total household wealth, in comparison to the 8 or 9 percent share of income received by the top percentile of the income distribution.”

Given the current US depreciation laws and related institutions, to lower the capital gains tax rate across the board is to steer capital and entrepreneurial resources into a search for unearned rather than earned income. It rewards real estate speculators and corporate raiders as it shifts the burden of taxation to people whose primary source of income is their labor. The budget crisis aggravated by such a policy also ends up forcing public resources to be sold off to meet current expenses -- sold to the very wealth-holders being freed from taxation. In this way wealth consolidates its economic power relative to the rest of society, and translates it into political power so as to shit? the tax burden onto the shoulders of others. The first element of this strategy has been to defer revenue into channels that are taxed only later, as capital gains. The second has been to tax these gains at a lower rate than earned income -- a fight that has broken out in earnest following the 1996 presidential elections. ...

Economic policy should distinguish between activities which add to productive capacity and those which merely add to overhead This distinction elevates the policy debate above the level of merely carping about inequitable wealth distribution, an attack by have-nots on the haves, to the fundamental issues. What ways of getting income deserve fiscal encouragement, and how may economic surpluses best be tapped to support government needs? Policies that subsidize rentier incomes while penalizing productive effort have grave implications, not only for distributive justice and social harmony, but also for economic efficiency and growth. Read the whole article

see also:
The Land-Residual vs. Building-Residual Methods of Real Estate Valuation, http://www.michael-hudson.com/articles/realestate/0110LandBuildingResidual.html

The Methodology of Real Estate Appraisal: Land-Residual or Building-Residual, and their Social Implications http://www.michael-hudson.com/articles/realestate/0010NYURealEstate.html

How to lie with real estate statistics: The Illusion that Makes Land Values Look Negative; How Land-Value Gains are Mis-attributed to Capital http://www.michael-hudson.com/articles/realestate/01LieRealEstateStatistics.html

Where Did All the Land Go? - The Fed’s New Balance Sheet Calculations: A Critique of Land Value Statistics http://www.michael-hudson.com/articles/realestate/01FedsBalanceSheet.html

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