Value capture is an increasingly popular concept that seeks to capture for public benefit all or part of the increments in land value resulting from community, rather than private, investments and actions. Yet, based on the Lincoln Institute’s experience in sponsoring many educational and research programs dealing with value capture policies in Latin America, it is also quite controversial.

This article addresses some of the contentious and persistent issues that have engaged participants in the ongoing debate over value capture, ranging from basic concerns, such as the proper understanding of the legal basis for land property rights, to larger political questions raised by new or higher charges on real estate property. Technical issues also are involved, such as distinguishing land value increments (or plusvalías) attributed to specific public investments or planning decisions from other more general sources or factors that influence land markets, as well as pragmatic challenges that arise in selecting the right instrument for the right circumstances at the right time.

To gain a better understanding of value capture, one cannot rely simply on technical arguments or expert authorities. At the same time, one cannot dismiss the issue on purely political grounds by attributing the main obstacles to the implementation of value capture policies to well-positioned interest groups. Rather, a considerable share of the “unexplained variance” in the application of value capture seems to be the result of inadequate information or misunderstanding held by major stakeholders in the debate.

Figure 1 summarizes 10 contentious value capture issues; items 1, 2 and 3 are discussed briefly below.

Unfair Charges for the Poor

Although support for direct subsidies or grants to the poor is waning in Latin America, many still believe that the poor should not pay for urban services, or should be exempted from taxes and other charges on their land, as is required by many of the more progressive value capture policies and laws.

A common argument in favor of exempting the poor from such charges raises an intergenerational dilemma: since wealthy residents for many years have enjoyed urban services that they did not pay for, why should the poor be charged now for services that they need and deserve? Another argument centers on the idea that most land value increments in poor areas have in fact been generated by the poor themselves, through sweat equity or private schemes to access basic services in their areas, not through public intervention. Some recognize that urban upgrading programs simply bring poor settlements to the first stage of the urbanization process, which is a bare minimum for participation in regular land markets. Others believe that even a socially neutral value capture instrument may produce a regressive result, perpetuating the disparity between the rich and the poor in the context of inequitable access to urban facilities and services, as is the case in most Latin American cities (Furtado 2000).

On the other end of the spectrum are those who argue that value capture payments are part of the poor sector’s claim to full citizenship, including the right to demand attention from the government. There are many examples where the poor have been eager to pay for receiving services (such as water systems, public lighting and flood control) since the cost of not accessing them is perceived to be higher than the actual payment. This was the case in Lima, Peru, in the early 1990s when more than 30 poor communities participated in a public service program that included payment for the cost of the services provided.

A more theoretical and perhaps less intuitive argument considers the capitalization effect of any charge on land prices. That effect is the reduction (or increase) of the current market price of land by the capitalized or discounted sum of the costs (or benefits) affecting the future earnings the property is expected to generate. To the extent that value capture charges on regularized or upgraded areas are integrated in the expectations regarding the future burden imposed on unserviced land bought from illegal or pirate subdividers, they would tend to be capitalized in the price that buyers would be willing to pay or the subdivider was able to charge (Smolka 2003). Although the poor would end up paying the same amount over time, the money would go to the local public treasury rather than the subdivider’s pocket.

Incidently, a common but mistaken view holds that such charges (value capture or land value taxes) are inflationary or increase the market price of land. Although the capitalization effect is complicated, most people can understand a situation comparing two otherwise identical apartments, where the one located in a building with a higher condo fee would get a lower rent in the marketplace than the apartment with a smaller fee. The same line of reasoning may be used to explain why there is no double taxation between value capture and the property tax. The relevant land value increment resulting from some public intervention accumulates or adds to an observed base market price that already is net of the capitalized effect of any anticipated future benefits or burdens, including the property tax.

Acquired Rights When Changing Land Uses

Although few would argue that expectations play a crucial role in determining land prices, it is widely considered unfair if price compensation falls below current market prices. This idea is now beginning to change, as reflected in recent legislation. For example, Law 388 of 1997 in Colombia allows for public acquisition of land at fair market prices, but not including the increment of land value resulting from previous public investments or changes in regulatory land uses (see article by Maldonado and Smolka, page 15). The same principle is stated in Brazil’s new City Statute (Law 10.257 of 2001) when land expropriation is used as a sanction against a landowner who is not complying with social uses of the land. Many lawyers agree that expectations do not create rights; therefore, expectations not realized should not be compensated. The social unrest around public land acquisition that led to the postponement of Mexico City’s proposed new airport mega-project vividly illustrates this problem.

It is hard for the typical landowner who in good faith bought a piece of land with the expectation of using its development potential to understand why he should not be compensated for the loss of that land at the current market price or at least the acquisition price, even if the development rights had not been exercised. However, the result often depends on the extent to which the new policy is actually implemented. In practice, prices reflect expectations regarding the (usually weak) enforcement of existing legislation, including legal variances or loopholes in the relevant fiscal and regulatory environment. This has been the case in most court decisions regarding fair compensation on public land acquisition processes and on claims from landowners (or developers) on whom local administrations impose plusvalías charges. A more pragmatic argument is that rights may indeed be restricted by a new legislation or zoning code, as long as it is accompanied by adequate transition rules to protect the rights of those who had previous legitimate claims. Others defend the transition process as an indispensable step toward allowing the market to gradually absorb such changes.

Economists struggle to convey the importance of expectations in determining the structure of current observed land prices. How the future affects current land prices is in fact harder to express to the general public than the notion that current prices reflect rights as realized in comparable properties in the past. In Latin America expectations associated with land uses are not always related to zoning or building codes, but rather to land speculation. It may be of interest to note that whereas speculation in Latin America is associated with long-term retention of land, in North America it is associated more with rapid turnover of properties. The phenomenon of land retention for future development, with the consequent private appropriation of unearned increments in land values, has stymied urban planning and development ever since cities began expanding rapidly over many decades.

Asymmetrical Compensation for Wipeouts

The debate over value capture (i.e., capturing land value increments, windfalls or plusvalías) inevitably raises the question: What about the wipeouts (minusvalías)? The common perception is that governments are more eager to approve legislation to capture land value increments than to provide legal protections for citizens against takings or arbitrary compensation for equally predictable losses (minusvalías). The Latin American record has shown, however, that the balance between the plusvalías captured and the minusvalías paid for is clearly negative. The amount paid in compensation to landowners surpasses by far the small and sporadic gains the public has been able to recover from the direct benefits it generates for private properties.

All rents, and land prices for that matter, are in essence nothing more than accumulated plusvalías, or land value increments, over time, echoing Henry George’s argument for full confiscation of land rents. Thus, the alleged minusvalías are considered incidental and just part of a value to which individual rights are not (or should not be) absolute. The debate on this asymmetry bears directly on the proper definition of wipeouts and on how those losses are understood, which raises the issue of development rights. While some are willing to restrict the compensation for land and building improvements that the owner may lose, others argue that development rights are permanently built in as an inherent attribute of the land.

In practice it is not easy to make these arguments. What may be valid in the aggregate does not necessarily hold true for the part, since individual landowners consider it a loss in land value when, for example, a walled expressway cuts across their back yard or a viaduct blocks their view and produces noise and pollution. The average citizen is not easily convinced by the above arguments. The quest for symmetrical treatment is too socially and culturally sensitive to be ignored.

Transfer of development rights (TDRs)—an instrument originally conceived for compensating minusvalías from historical, architectural, cultural or environmental preservation ordinances for plusvalías somewhere else—has now been extended to mitigate other legitimate claims for minusvalías compensation. Some argue that regular compensation for wipeouts is a guarantee, making it easier to accept payments for windfalls. Under the equity principle, planning decisions including zoning schemes are recognized as potentially unfair with regard to the distribution of values in land markets. However ingenious the TDR instrument may appear, it does not help clarify the issues at stake. On the contrary, it adds to the debate since it simultaneously recognizes the right for minusvalías to be compensated and sanctions the right of individuals to plusvalías, reintroducing the question of private appropriations of community values.

Final Comments

The complex debates over value capture policies and instruments in Latin America indicate that much remains to be researched and learned. If the issues do not necessarily have a single answer, the arguments discussed here demonstrate that a significant portion of the resistance to such ideas may be attributed to misconceptions and insufficient information. Although the positions taken by different groups are not as clear-cut or coherent as expected, perceptions and attitudes do change, as the accompanying article indicates.

Martim O. Smolka is a senior fellow and director of the Lincoln Institute’s Program on Latin America and the Caribbean. Fernanda Furtado is a fellow of the Institute and a professor in the Urbanism Department at the Fluminense Federal University in Niteroi, Brazil.

References

Furtado, Fernanda. 2000. Rethinking value capture policies for Latin America. Land Lines 12 (3): 8–10.

Smolka, Martim O. 2003. Informality, urban poverty and land market prices. Land Lines 15 (1): 4–7.

Figure 1: Contentious Propositions and Commentaries on Value Capture

Proposition Commentary

1. It is unfair to charge the urban poor who benefit from regularization or upgrading programs. Evidence shows that expectations regarding publicly funded future upgrading programs lead to higher markups or premiums on current land prices in irregular or illegal settlements. Charging for such benefits would simply switch the recipient of a payment burden that is already being imposed on the poor from the subdivider to the government collecting the charge.

2. Urban land policy must take into account previous development rights, for they are acquired rights. Although expectations are an important part of land market prices, they do not create rights. Zoning designations or development rights, when not realized, are not acquired rights and therefore they can be taken without compensation.

3. Minusvalías are not compensated for; the asymmetry between plusvalías and minusvalías is unfair. Minusvalías are the exception in Latin American cities where land value increments are much higher than the cost of servicing land. In practice, however, public compensation to private owners usually far surpasses collection through value capture policies.

4. Land value capture policy is “communist.” Paying for “free rides” is certainly not a communist idea. One is reminded of mainstream economic theories regarding the merits of a system where individuals and social costs and benefits converge at the margin.

5. Value capture over and above the property tax implies double taxation. In effect, observed land prices to which land value increments apply are already net of the capitalization effect of property tax on land values.

6. Value capture distorts the functioning of the land market. In actuality, it’s the opposite: uncontrolled land value increments distort the behavior of agents. The presence of plusvalías is as distorting a factor for urban development as inflation is for economic development in general.

7. Private appropriation of land value increments is no more objectionable than similar windfalls obtained in capital markets. There is a fundamental conceptual difference. In capital markets equity and bonds are issued against productive investments as collateral for increases in productivity in individual businesses. In the land market, by contrast, land value increments result from the community effort, not individual effort.

8. Value capture is technically impractical because it is impossible to measure the land value increment. With the technical resources available today it is ludicrous to think it “can’t be done.” Ingenious and practical solutions have been developed in Cartagena, Colombia, and Porto Alegre, Brazil, for example.

9. Value capture is overwhelmingly rejected by the citizens, and therefore is politically impractical. The privileged few are the main source of rejection, not the poorer majority of the population who often are charged higher prices in order to access public services through informal arrangements.

10. The amount that can be collected with supplementary value capture instruments is a negligible amount in the public budget. Because of limited collection of the property tax in Latin America, value capture resources can assume an important role in financing urban development. Besides, use of value capture brings to light plusvalías, which has traditionally been a key source of corruption, and thus contributes to a healthier fiscal environment.

The property tax is the most widely unpopular tax in America. States have responded to this public opposition by enacting a range of tax relief policies, especially for homeowners (Cabral and Hoxby 2012). Among the most commonly adopted programs are homestead exemptions and property tax credits; all but three states have at least one of these programs. But despite their broad use and their potentially large impact on the distribution of property tax burdens, there has been remarkably little data available on the tax savings generated by property tax exemptions and credits.

Two new resources, available through the Lincoln Institute’s Significant Features of the Property Tax subcenter, begin to fill this need. These tables provide information for each state on the share of homeowners eligible for these programs and the level of tax savings they receive, as well as an analysis of how eligibility and benefits vary across the income distribution (see box 1, p. 26). This article draws on these resources to provide the first national study of property tax exemptions and credits with estimates of tax savings from these programs. With this information, policy makers have a critical tool to evaluate and improve the effectiveness of their property tax relief programs.

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Box 1: State-by-State Details on Property Tax Exemptions and Credits

The Significant Features of the Property Tax sub-center provides three key resources with information on property tax exemptions and credits in all 50 states; it is accessible at www.lincolninst.edu/subcenters/significant-features-property-tax.

Tax Savings from Property Tax Exemptions and Credits

This online Excel file includes estimates of tax savings from programs in individual states (see abbreviated example below), plus overview tables that make it easy to compare across states. For each program, the file provides estimates of the number of eligible homeowners and the median benefit, as well as a distributional analysis by income quintile. This is the first time that detailed data are available for most of these programs.

Summary Table on Exemptions and Credits

This online Excel file includes a set of tables for 167 programs displaying the value of exemptions expressed in terms of market value; criteria related to age, disability, income, and veteran status; the type of taxes affected (i.e., school or county taxes); whether the tax loss is borne by state or local governments; local options; and more. The summary table makes it easy to conduct quantitative analysis of these programs or make quick state-by-state comparisons. The information in these tables was used to generate the tax savings estimates.

Residential Property Tax Relief

This section of the Significant Features website includes detailed descriptions of property tax exemptions and credits, which were used to create the online Summary Table on Exemptions and Credits. It also describes other types of property tax relief, such as circuit breakers and tax deferral programs.

Notes: Total tax savings from the Senior and Disabled Property Tax Homestead Exemption ($392M) is less than the combined total of the programs for Seniors ($378M) and the Disabled ($22M), because homeowners who are 65+ and disabled cannot claim the exemption twice. The online Summary Table shows that the Senior and Disabled Exemption is a $25,000 exemption for homeowners who are 65+ or disabled; the two Rollback programs are percentage exemptions of 2.5% and 10% for all owner-occupied residences. Source: Lincoln Institute of Land Policy (2015).

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How Property Tax Exemptions and Credits Work

Property tax relief programs come in a variety of forms. Homestead exemptions reduce the amount of property value subject to taxation, either by a fixed dollar amount or by a percentage of home value. Property tax credits, in contrast, directly reduce the homeowner’s tax bill by a fixed dollar amount or certain percentage.

As table 1 illustrates, programs designed to provide identical benefits to owners of $200,000 homes have widely different impacts on homeowners with higher- and lower-valued properties. Given a 1% tax rate, a $20,000 flat dollar exemption reduces property taxes for each homeowner by $200 ($20,000 x 1%). This program has a progressive impact on the property tax distribution because lower-income households tend to have less valuable homes, and the exemption represents a larger share of their home values. In this case, the $20,000 exemption reduces property taxes by 20% on the $100,000 home, 10% on the $200,000 home, and 5% on the $400,000 home.

A percentage exemption, in contrast, provides the same percentage reduction in taxes for all three homeowners—in this example, 10%. In dollar terms, however, percentage exemptions favor owners with higher-valued homes: a 10% across-the-board reduction lowers property taxes by only $100 on the $100,000 home but $400 on the $400,000 home.

In the case of flat dollar credits, homeowners with lower-valued homes usually receive the largest tax cuts in percentage terms. In contrast, the percentage tax credit again provides the owner of the $400,000 home the largest tax cut in dollar terms.

An important feature of property tax exemptions and percentage credits is that the dollar reduction (but not the percentage reduction) in taxes increases with tax rates. For instance, if the homes in table 1 were subject to a 2% tax rate, the dollar savings to their owners would double under the $20,000 exemption, 10% exemption, and 10% credit. While the dollar savings from flat dollar credits do not vary with tax rates, the percentage savings to homeowners decrease as tax rates rise.

Critical Features of Exemptions and Credits

The design of homestead exemption and property tax credit programs varies significantly across the 50 states. Figure 1 (p. 28) summarizes the number and share of state programs with the following key characteristics.

Benefit Calculation

Perhaps the most important feature of property tax relief programs is how benefits are calculated. In 2012, 59% of state programs provided flat dollar exemptions, 19% provided percentage exemptions, and the final fifth used property tax credits or other more complicated formulas to determine the amount of tax relief for each homeowner.

While the programs work in similar ways, their effects differ dramatically. As the examples in table 1 show, flat dollar exemptions and credits make the property tax distribution more progressive, while percentage exemptions and credits do not. As a result, to provide a certain level of tax relief for the median homeowner, percentage exemptions are more expensive than other programs because they result in larger property tax cuts for owners of higher-valued homes. Instead of changing the distribution of property taxes among homeowners, percentage exemptions are primarily a way to shift the tax burden away from homeowners as a group to businesses, renters, and owners of second homes.

State vs. Local Funding

The ultimate impact of exemptions and credits on property tax bills depends on how the programs are funded. Figure 1 shows that in 2012 only 28% of these programs included full state reimbursement to cover local revenue losses, while 57% had local governments bear revenue losses on their own. For 15% of programs, state and local governments shared the revenue loss in some way. (Broad-based programs for all homeowners or all seniors are more likely to receive state funding than programs for smaller groups such as veterans or the disabled. In 2012, 43% of tax relief programs for all homeowners or seniors were state-funded, 48% were locally-funded, and the rest split the revenue loss [Lincoln Institute of Land Policy 2014].)

The primary argument in favor of state funding of property tax exemptions and credits is that it can help mitigate disparities in property wealth across localities. Poorer communities and those without a significant business tax base typically have higher property tax rates, and these communities receive more funds per homeowner under state-funded programs. Without this assistance, communities with higher tax rates will experience larger revenue losses from tax relief programs unless they increase tax rates even further.

Seniors vs. All Age Groups

A number of states provide property tax relief for seniors. In 2012, more than a third favored seniors in some way: seven had statewide programs solely for this group, while 11 also covered younger homeowners but provided higher benefits for older homeowners. Other states provided either the same level of benefits for homeowners of all ages (15 states) or did not have broad-based programs (18 states).

Common arguments for targeting senior homeowners is that property taxes account for a larger share of their incomes, and local governments spend less on seniors than on younger homeowners with school-aged children. While it is true that property taxes account for a larger share of income for seniors than for working-age homeowners, the two groups devote nearly identical shares of their incomes to total housing costs because seniors are far less likely to have mortgages (Bowman et al. 2009, 11). In addition, property taxes are payments for public services, not user fees (Kenyon 2007, 36). Younger households without children in public schools do not benefit from property tax relief under these programs. The preferential tax treatment of seniors may simply reflect the fact that older households are a politically powerful group that votes in high numbers.

Estimating the Benefits of Exemptions and Credits

To estimate tax savings from homestead exemptions and property tax credits, the first step was to create the online Summary Table on Exemptions and Credits, which describes the key features of each program (see box 1 for description). These data draw almost entirely from the Residential Property Tax Relief Programs section of the Lincoln Institute’s Significant Features of the Property Tax database.

The second step was to combine this information with household-level data from the 2008–2012 American Community Survey (ACS). This nationally representative survey has data on more than 6.5 million U.S. households, including the household characteristics that determine program eligibility (age, income, disability, veteran status, etc.) and level of benefits received (home values and property tax bills). For a full explanation of the methodology used to estimate tax savings from exemptions and credits, see Langley (2015).

It is important to note that the estimates reported here are gross property tax savings. Tax relief programs often lead to higher property tax rates, especially under locally-funded programs where jurisdictions raise tax rates to offset the drop in the tax base from the exemptions. Estimates of net property tax savings would be lower in those communities, because the higher tax rates offset some of the direct tax relief provided from exemptions and credits.

Figure 2 shows that total property tax relief from homestead exemptions and property tax credits varies widely across states, but is generally small relative to total property tax revenues. In 14 of the 45 states with these programs, total savings are less than 0.5% of property tax revenues; in 27 states, the savings are less than 2.5%. At the same time, though, tax savings in nine states equal or exceed 10% of total property tax revenues. Indiana’s program is particularly generous, offering all homeowners a $45,000 exemption, then an additional 35% exemption for the first $600,000 in assessed value and a 25% exemption for value above $600,000.

Tax Savings for Different Types of Programs

Most states have more than one property tax exemption or credit program, with different programs targeting different groups of taxpayers—typically all homeowners, seniors, veterans, or the disabled. Figure 3 presents estimates on the share of homeowners eligible for these programs, along with the level of tax savings they receive.

Homeowners

Programs in 26 states are for nearly all homeowners, but usually limited to owner-occupied primary residences. In the typical state with these programs, the median homeowner receives a 12.5% cut in property taxes. On the high end, however, the median property tax cut was at least 25% in more than a quarter of states with these programs.

Seniors

Property tax relief programs in 18 states target older homeowners (typically at least age 65). These programs are much more generous than those covering all homeowners, with a median tax reduction of nearly 30% in the typical state. More than half of these programs provide a median tax cut of at least 25%, while only a sixth of them provide a median tax savings of less than 10%.

In the median state, 19.6% of homeowners are eligible for the programs, but eligibility rates vary greatly across states depending on whether there is an income ceiling. In the seven states that provide property tax relief to seniors regardless of income, 25–30% of homeowners are typically eligible. But in seven states with low income cutoffs ($10,000 to $30,000), only 5–10% of homeowners qualify. The other four states with property tax relief programs for seniors do not fit neatly into these two categories because they have higher income ceilings, strict wealth limits, or other eligibility criteria.

Veterans

State programs for veterans are more common than for any other group of homeowners, although eligibility is often limited to those who are disabled. Indeed, only 10 states provide property tax exemptions or credits for all veterans, even those without disabilities. In the median state with these programs, the typical beneficiary receives a property tax cut of just 3.2%.

There are 31 states that provide property tax exemptions or credits to veterans with service-connected disabilities. Because of the disability requirement, most veterans are ineligible for the programs. Indeed, only 15% of veterans qualify in the typical state. Overall, just 0.6% of homeowners are eligible for these programs in the median state.

Moreover, most of the 31 programs base eligibility and benefit levels on disability ratings from the Department of Veterans Affairs. Just seven states have programs for all partially disabled veterans, and veterans with lower disability ratings typically receive modest tax savings. On the other hand, 18 states restrict eligibility to veterans who are permanently and totally disabled. These programs benefit a very small share of veterans, but they usually provide a full 100% exemption.

Disabled

Programs in 23 states cover disabled homeowners, but really target two distinct groups: disabled homeowners and blind homeowners. In 2012, 12 states had programs for disabled homeowners, seven states had programs for the blind, and five states covered both groups. Programs for the disabled typically require beneficiaries to be permanently and totally disabled, but exact criteria vary. In the median state, 2.3% of homeowners are eligible for these programs and they receive a median property tax cut of 21%.

Conclusion

Homestead exemptions and property tax credits are an important part of the property tax system. These programs are used in nearly all states and can make the distribution of property taxes significantly more progressive. It is therefore critical that policymakers have good data on the property tax relief that these programs actually provide.

New research makes this information available for the first time. Using the Lincoln Institute’s Significant Features of the Property Tax subcenter, policymakers can easily compare key features of property tax exemption and credit programs across states, and see estimates of eligibility and tax savings. These data make it possible to evaluate the impacts of property tax exemptions and credits in their particular states as well as find ideas for program improvements.

Adam H. Langley is Senior Research Analyst at the Lincoln Institute of Land Policy. Special thanks go to Andrew Reschovsky, who provided extensive comments on this article and other related papers.

References

Bowman, John H., Daphne A. Kenyon, Adam Langley, and Bethany P. Paquin. 2009. Property Tax Circuit Breakers: Fair and Cost-Effective Relief for Taxpayers. Cambridge, MA: Lincoln Institute of Land Policy.

Cabral, Marika, and Caroline Hoxby. 2012. “The Hated Property Tax: Salience, Tax Rates, and Tax Revolts.” Cambridge, MA: National Bureau of Economic Research. Working paper 18514. November.

Kenyon, Daphne A. 2007. The Property Tax-School Funding Dilemma. Cambridge, MA: Lincoln Institute of Land Policy.

Langley, Adam H. 2015. “Estimating Tax Savings from Homestead Exemptions and Property Tax Credits.” Working paper. Cambridge, MA: Lincoln Institute of Land Policy.

Lincoln Institute of Land Policy. 2014. Significant Features of the Property Tax. Residential Property Tax Relief Programs: Summary Table on Exemptions and Credits in 2012. www.lincolninst.edu/subcenters/significant-features-property-tax/Report_Residential_Property_Tax_Relief_Programs.aspx

Lincoln Institute of Land Policy. 2015. Significant Features of the Property Tax. Tax Savings from Property Tax Exemptions and Credits in 2012. www.lincolninst.edu/subcenters/significant-features-property-tax/Report_Residential_Property_Tax_Relief_Programs.aspx

Municipalities across the United States face social problems caused by high land prices and a shortage of affordable housing. Dick Netzer, professor emeritus of economics and public administration at the Wagner Graduate School of Public Service at New York University, discusses the role that land taxation might play in addressing these issues. Netzer is a long-time faculty associate of the Institute and is the editor of several Institute publications, including Land Value Taxation: Can It and Will It Work Today (1998).

Land Lines: Could a land tax affect the building portion of the housing supply?

Dick Netzer: Yes. This is a point on which it is useful to distinguish the effect of taxes on land, capital and labor. A change in the tax system that affects the return on an investment in any of these factors will affect the amount that is invested, because a higher rate of return will encourage more investment in that factor and increase its supply. Here, of course, land is an unusual factor of production, because for most purposes we can consider the supply of land as fixed. An increase in demand will not produce an increased supply of land, and reduced demand will not decrease the supply.

On the other hand, lower taxes on capital and labor will cause their supply to increase because of the increased net return to these factors. So a tax shift that reduces taxes on capital and labor and increases taxes on land will increase the supply of capital and labor but not reduce the supply of land. Building construction is a very capital-intensive industry, and an increased supply of capital and labor, reflecting their higher after-tax rewards, will allow more building construction to take place.

LL: How would a land tax affect the price of land?

DN: We can assume that the pre-tax prices reflect “what the market would bear,” and that imposition of a tax will not increase demand or raise the amount that buyers would be willing to pay for land. In that case, the total amount buyers will pay, including the new tax that they will face, will be unchanged. But the division of that payment will change. Less will go to the seller, and that will be balanced by the increased tax that will be paid to the government. We need to distinguish here between short-term and long-term effects. In the long term, the price does not change—it just is divided differently between the seller and the government. But the short-run outlay does change, because the tax is a periodic charge over time, while the price paid to the seller is a lump sum, or requires a mortgage and a down payment. Reducing the lump-sum component and increasing the periodic charge can ease liquidity problems, making land more accessible to purchasers who cannot readily raise large amounts of cash but who can meet their tax obligations.

LL: So the overall effect would be to help make housing more affordable?

DN: Yes. Together these effects on building supply and on land prices should result in lower rents and lower housing prices. Note that this is not a direct effect of increasing land taxes, but an indirect effect as a consequence of untaxing labor and capital.

LL: How do you analyze our current shortage of affordable housing?

DN: Since landowners are currently able to command an outsized return on their landholdings, tenants are paying higher rents than one would expect if the returns to land ownership were more modest. We are fortunate to live at a time when demand for housing is increasing—and so is demand for land on which to build new housing or to renovate existing housing. When demand rises for a product in fixed supply, prices generally rise as well. But this rising demand and these rising prices are not the result of actions by landowners themselves. So there is neither an economic need nor an equitable requirement that this increasing demand produce larger returns to landowners.

LL: What would the economic transition to higher land taxes look like?

DN: In a period when housing demand is rising, one solution would be to increase the tax on land values while reducing taxes on labor, machinery and other productive equipment. First, let’s consider the effect of untaxing labor and capital to some extent. A reduction in taxes on labor and machinery will allow people who offer their labor and savings to earn more after taxes. When these earnings increase, we would expect that more labor and savings will be offered, which in turn will cause some reduction in earnings, but not enough to drive the supply to its previous levels. Because the costs of construction and the cost of equipment will be lower, the prices that consumers pay for new housing will decline.

I don’t want to overstate the scale of this effect. If housing demand is very strong, the effects on prices are likely to be modest, but the supply of housing will increase. The net result will be to dampen increases in housing prices and rents.

LL: What about the effect of the transition on land prices themselves?

DN: That is the other part of the tax shift. Right after such a change in the tax system, the prices of land for new buyers will fall sharply, because along with the land they are buying an obligation to pay the new, higher land taxes. So homebuyers and renters, as well as homebuilders, will face lower immediate prices for land, offset by the higher taxes they will pay over time. Even with this offset, they will be in a better position than they were before the tax shift. There will be a significant lowering in the need for cash when homebuilding begins, when a home is purchased, and when rental property is sold to new investors. These are critical times for homebuyers and for investors in residential property, and a reduction in their cash requirements at these points can be a great benefit. Of course, they will have to pay the higher land taxes each year. But these taxes do not require an advance lump-sum payment, and they require no mortgage or construction loans. These positive liquidity effects can be very important in housing markets—perhaps not to the very largest commercial homebuilders or to the most affluent buyers, who may not require a mortgage at all, but very important to ordinary participants in the housing market.

LL: What about existing landowners who suddenly face higher taxes?

DN: This is a genuine issue, and there may well be negative liquidity effects for them. The sale value of their land will fall immediately and substantially. If so, they may be less willing or able to withhold their land from the market in hopes of gains from increases in market values in the future.

We can expect another impact on land taxes, in a different direction. The lower prices on labor and equipment will cause a greater investment in housing and other construction. That means there will be more demand for land, and this increased demand will raise land prices. However, this rise will be of a different character from the price increase that we considered at the beginning of this discussion, which represented an outsized return to landowners. Unlike speculative price increases that stem from expectations of even higher prices in the future, the rise in land values resulting from increased investment in labor and equipment will not outpace the increase in income generally. The knowledge that a large portion of the future gains will have to be paid to the government in the form of a high land value tax will prevent buyers from bidding up the price of land simply in expectation of those gains. This is a good example of the distinction between two types of price increases. The purely speculative increase produces outsized returns to current landowners but does not benefit society as a whole. A price increase that reflects greater availability of labor and capital can serve the function of allocating land among competing uses, which helps the economy function efficiently.