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Real
Estate and the Capital Gains
Debate
by Michael Hudson* and Kris Feder*
Working Paper No. 187
March 1997
*Research Associates,
The Jerome Levy Economics Institute of Bard College
1 Introductionby Michael Hudson* and Kris Feder*
Working Paper No. 187
March 1997
*Research Associates,
The Jerome Levy Economics Institute of Bard College
2 Depreciation and Capital Gains
3 How Mortgage Debt Converts Rent into Interest
4 Capital Gains Taxation in Real Estate
5 Government Statistics on Real Estate Asset Gains
6 The Political Context of Real Estate Taxation
7 Policy Conclusions
Charts and Tables
Chart 1. Capital Consumption Allowances By Sectorla Non-Corporate Capital Consumption
lb Corporate Capital Consumption
Chart 2. Real Estate Profit and Loss Compared to Cash Flow lb Corporate Capital Consumption
2a Real Estate Cash Flow of Individuals
2b Real Estate Cash Flow of Partnerships
2c Real Estate Cash Flow of Corporations
Chart 3. Net Business Interest 2b Real Estate Cash Flow of Partnerships
2c Real Estate Cash Flow of Corporations
3a Domestic Net Interest Paid by
Business (in billions of dollars)
3b Domestic Net Business Interest (percentage composition)
3c Net Business Interest (as percentage of national income)
3d Components of Domestic Net Business Interest (as percentage of total)
Chart 4. Gross Rental Revenue in the United States 143b Domestic Net Business Interest (percentage composition)
3c Net Business Interest (as percentage of national income)
3d Components of Domestic Net Business Interest (as percentage of total)
4a US Gross Real Estate Revenue (in
billions of dollars)
4b US Gross Rental Revenue (as percentage of national income)
4c Components of Gross Rental Revenue (as percentage of total)
Chart 5. Capital Gains as Reported to IRS-1985 4b US Gross Rental Revenue (as percentage of national income)
4c Components of Gross Rental Revenue (as percentage of total)
Table 1. The Evolution of Capital Gains Tax Rates
Chart 6. National Income Plus Capital Gains in Land-1985
Table 2. Estimated Land Gains as Percentage, 1985
I. Introduction
- THE CAPITAL GAINS CONTROVERSY
1 Capital gains received
preferential income tax treatment from 1921 through 1987. The Revenue
Act of 1942 provided for a fifty percent exclusion for noncorporate
capital gains or losses on assets held over six months; the Revenue Act
of 1978 raised the exclusion to sixty percent. These exclusions reduced
the effective rate from approximately 49 to 28 percent. The Economic
Recovery Act of 1981 reduced the effective rate still further, to 20
percent, as a result of the reduction in the top marginal tax rate from
70 to 50 percent. However, the Tax Reform Act of 1986 eliminated
exclusions for capital gains after 1988. Corporate capital gains were
taxed at an alternative rate of 25 percent with the Internal Revenue
Code of 1954, then at 30 percent with the Tax Reform Act of 1969. The
alternative rate was reduced to 28 percent by the Revenue Act of 1978,
and repealed by the Tax Reform Act of 1986, which provided for taxation
of (taxable) realized capital gains as ordinary income. Joint Committee
on Taxation (1990), p. 11.
2 Elving (1989), p. 2299.
3 Elving (1990), p. 1183.
4 “Capital Gains Study at a Standstill” (1991, anonymous), p. 594; Elving (1989) pp. 2299-2302.
5 Elving (1989), pp. 2299-2300.
2 Elving (1989), p. 2299.
3 Elving (1990), p. 1183.
4 “Capital Gains Study at a Standstill” (1991, anonymous), p. 594; Elving (1989) pp. 2299-2302.
5 Elving (1989), pp. 2299-2300.
An October, 1990 congressional budget agreement cut the maximum capital gains tax rate from 33 to 28 percent. The cut was less than the administration had sought, and Bush continued to press for further rate reductions; but significantly, it reestablished preferential taxation, as the maximum rate on ordinary income was now 31 percent.6
6Pollack (1991), p. 56.
Bush’s January 1991 budget proposal included provisions to reduce the tax rate on certain capital gains. Individuals would be allowed to exclude a percentage of the gain from qualified assets, the percentage increasing with the length of the holding period. The effective tax rate for an asset held three years or more, for example, would have been 19.6 percent for an individual in the 28-percent tax bracket.7
7 “In addition, all depreciation
would be recaptured in full as
ordinary income.” Joint Committee on Taxation (1990), p. 15. “The
proposal was introduced by Senators Packwood, Dole and Roth as S. 2071
. . . March 15, 1990.”
A year later, Congressional Democrats put forth their own plan to index capital gains for inflation, which, they argued, was a more equitable way to reduce effective tax rates. Opponents countered that the wealthy would benefit even more from indexing than from Bush’s plan — or that “indexing would not provide the quick stimulus that Bush claims would come from his proposal” to slash capital gains tax rates. While the proposal to index gains has continued support today, it is adamantly opposed by the Treasury on grounds of administrative unfeasibility.9
8 Cloud and Cranford (1992), p.
393.
9 Schlesinger (1997), p. A6.
Last year, the tax cut plan of Presidential candidate Bob Dole would
have halved capital gains tax rates, from 28 to 14 percent.9 Schlesinger (1997), p. A6.
Concern that a capital gains tax cut would eventually, after an initial sell-off, necessitate higher ordinary income tax rates to meet budget shortfalls “has kept the nation’s business community from monolithic endorsement of the proposals.“10
l0 Elving (1989), p. 2300.
However, proposals to cut capital gains taxes have increasingly
enjoyed bipartisan support in recent months, fueled partly by the
run-up of stock prices which has created huge paper gains. President
Clinton’s budget proposals of January 1997 called for a tax exemption
for up to $500,000 in capital gains from the sale of personal
residences, and it is reported that he has signaled his willingness to
contemplate a broad-based cut in future negotiations,
perhaps to a 20 percent maximum rate.11 A
bill introduced in January by Senate Republicans would reduce the
effective rate from 28 percent to 19.8 percent for individuals and from
35 percent to 28 percent for corporations, and would also index gains
for inflation. In February, Senate Democratic Majority Whip Wendell
Ford announced his support for a broad-based capital gains tax cut.12 As
The Wall Street Journal reports, “Prospects for a big cut in the
capital-gains tax seem better this year than at any time since the
federal government increased tax rates a decade
ago on profits from selling investments.“1311 McTague (1997), Barrens, Feb
2, 1997. URL: http:/lwww.barrons.com/bie/articlesl19970207ibudget.htm
12 Hitt (1997), p. A2.
13 Schlesinger (1997), p. Al.
12 Hitt (1997), p. A2.
13 Schlesinger (1997), p. Al.
WHAT IS MISSING FROM THE CAPITAL GAINS DEBATE?
The most frequently heard arguments for reducing capital gains taxes are:
(1) to reduce the “lock-in” effect, by which high tax
rates at
realization deter asset sales;14
(2) to relieve a disproportionate burden on homeowners;
(3) to compensate for the erosion of capital gains by inflation, as an alternative to indexing;15
(4) to end alleged double taxation of both capital stocks and income flows;
(5) to spur productive enterprise and investment; and
(6) to generate more tax revenue from the consequent growth in asset sales and productivity.
(2) to relieve a disproportionate burden on homeowners;
(3) to compensate for the erosion of capital gains by inflation, as an alternative to indexing;15
(4) to end alleged double taxation of both capital stocks and income flows;
(5) to spur productive enterprise and investment; and
(6) to generate more tax revenue from the consequent growth in asset sales and productivity.
14 Some argue that eliminating
step-up of basis at death would do more to reduce lock-in than a rate
cut. See Joint Committee on Taxation (1990), p. 2 1; Gaffney (1991).
15 For an analysis of the case for inflation indexing, see Gaffney (199 1).
This report calls attention to a neglected aspect of the capital gains
issue — one which bears importantly on the fifth- and
sixth-named
consequences.15 For an analysis of the case for inflation indexing, see Gaffney (199 1).
Much of the capital gains debate today focuses on the stock market. Business recipients of capital gains are characterized as small innovative firms making initial public offerings (IPOs). In recent years such firms have been responsible for a disproportionate share of new hiring. It is hoped that corporations will be able to raise money to employ more labor and invest in more plant and equipment if buyers of their stocks can sell these securities with less of a tax bite. Stock market gains thus are held to stimulate new direct investment, employment, and output.
Typical of the campaign to reduce capital gains taxes is a Wall Street Journal editorial, “Capital Gains: Lift the Burden.” Author W. Kurt Hauser argues that when the capital gains tax rate was increased from 20 percent to 28 percent in 1989, the effect was to deter asset sales, causing a decline in the capital gains to be reaped and taxed. He refers, however, only to stock market gains, and specifically, to equity in small businesses. Citing the example of yacht producers, he suggests that taxing capital gains on stocks issued by these businesses “locks in” capital asset sales, thereby deterring new investment and hiring, and reducing the supply of yachts.16
16 Hauser (1995).
Others contend that new productive investment is relatively insensitive to capital gains tax rates, arguing, for example, that most of the money placed in venture-capital funds come from tax-exempt pension funds, endowments, and foundations.17
17 Venture Economics Information
Services, cited in Schlesinger (1997), p. A6.
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.1818 Federal Reserve Board,
Flow-of-Funds Statistics, Balance
Sheets for the US Economy. See section 5 regarding
capital gains on
land and buildings.
The Federal Reserve Board estimates land values at some $4.4 trillion for 1994. Residential structures add $5.9 trillion, and other buildings another $3.1 trillion. This $13.4 trillion of real estate value represents two thirds of the total $20 trillion in overall assets for the United States economy.19 Real estate accounts for three-fourths of the economy's capital consumption allowances. It also is the major collateral for debt, and generates some two-thirds of the interest paid by American businesses. Real estate taxes are the economy's major wealth tax, although their yield has declined as a proportion of all state and local revenues, from 70 percent in 1930 to about one-fourth today.
19 Balance Sheets for the U.S.
Economy: 1945-94, Table B.11.
Capital gains statistics are much harder to come by. One cannot simply
measure the increased value of the capital stock, for part of the rise
represents investment—production of new capital — rather than
appreciation of existing capital and land. The IRS conducts periodic
sampling of capital gains based on tax returns, and its Statistics on
Income presents various analyses of the shares of total capital gains
reported by the economy's income cohorts, from the richest five percent
down. The samples are admittedly asymmetrical, however, and some of the
categories overlap. Significantly, for instance, stock market gains
include a large component of land and other real estate gains. 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.
1 a.
Non-Corporate Capital Consumption
(Depreciation) as Percentage of Non-Corporate Capital
Consumption Allowances 1929-1993: Services, Wholesale/Retail Trade,
Manufacturing/Construction,
Transportation/Utilities, Agriculture-Forestry-Mining, Real Estate.
Source: NIPA
1b.
Corporate Capital Consumption,
as percentage of Economy-wide Corporate Capital Consumption Allowances:
Manufacturing/Construction, Transportation/Utilities, Real Estate
Source: NIPA
- 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.
20 Gaffney (1994a).
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.
2a.
Real Estate Cash Flow of Individuals (Whose Major Business Is Not
Real Estate), In Billions of Dollars 1929-1993
Source: NIPA2b.
Real Estate Cash Flow of Partnerships, in Billions of Dollars,
1970-1992
Source: NIPA
2c.
Real Estate Cash Flow of Corporations, in Billions of Dollars,
1929-1993
Source: NIPAThe 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.21 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.22 These three symbiotically linked sectors thus were left with only capital gains taxes to pay on their cash flow.
21 US Bureau of Economic
Analysis, NIPA Table 6.18.
22 NIPA Table 6.12.
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.
Capital gains already are being taxed much more lightly than ordinary income, especially when deferrals and exemptions are taken into account. Even if exemptions were eliminated and the capital gains tax rate were set as high as the ordinary income tax rate, the effective burden (what economists call the present value of the tax) would be substantially lower to the extent that the capital gains tax is paid only retroactively, upon realization (sale) rather than as the gains actually accrue.
One therefore must doubt the claim that cutting the capital gains tax would increase government revenue by encouraging investors to sell their assets. Kurt Hauser’s editorial asserts that “trillions of dollars are locked up in mature, relatively non-productive low-cost assets,” but does not explain that most of these “mature” assets take the form of depreciated real estate. Although real estate prices have stagnated, the book value of buildings has been diminished by much more. Now that these buildings are fully depreciated, owners have an incentive to sell or swap them once again so as to continue sheltering their income. The effect has been to leave substantial capital gains to be declared in the near future, while the properties can be sold for much more than their depreciated value.23
23 In these statistics we find
the explanation for the fact that
reported capital gains have fallen off since 1989. The reason is not,
as Hauser (1995) claims, because the capital gains tax hike has induced
fewer sales of stocks or direct business assets that have increased in
value, but because the collapsing real estate bubble has left in its
wake fewer land-value gains to be taken. Even assuming that investors
were sensitive to the increased capital gains tax rate, there have been
fewer gains to reap since prices peaked in 1989.
While it is often true that the prospect of earning capital gains is
what induces new investment to be made, applying further rate cuts to
real estate gains cannot be expected to spur much new construction
activity under present fiscal institutions. Clearly a “capital” gains
tax cut cannot cause the production of more land; land (as distinct
from capital improvements) is made by nature, not by the landowner. As
to buildings, more of the tax benefit would go to speculators in
existing capital than to investors in construction and renewal. We also
doubt that a further rate reduction is likely to accelerate real estate
turnover by reversing a “lock-in effect.” Turnover is strongly affected
by depreciation rates. In periods of rapid write-offs — most
strikingly
during the 1980s, when real estate could be written off faster than in
any other period — buildings tend to be sold as soon as they are
depreciated. The 1986 reforms reduced the incentives for this rapid
turnover, but the principle is clear: When depreciation rates are high,
there is a powerful tax-induced incentive to sell a building when it is
fully depreciated.24 The
basic motivation at work, of course, is to avoid taking investment
returns as taxable income. Investors prefer to declare as much of their
income as possible in the form of capital gains, which are taxed later
and at a lower rate.24 For an analysis of lock-in
and capital gains taxation, see Gaffhey (1990).
Sound tax policy requires an understanding of the fiscal
assumptions which underlie our tax code and the mythical world of
national income accounting. Far from being a potent stimulus to new
investment, a general capital gains tax cut would preferentially
benefit owners of already depreciated buildings speculators in already
seasoned stocks, leading to further deterioration of economic health.
It cannot be expected to raise the volume of capital gains declared by
enough to increase the total tax revenue generated.2. 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.
Industrial investors must pay tax on their accruals of unsold inventories as they mount up, as if they were sold for cash. Publishing companies, for instance, owe taxes on books that remain unsold at the end of the year, which leads to fast liquidation of such inventories and often to the pulping of unsold books. A shift in publishing policy has taken place toward faster sellers and smaller print runs.
Factory owners usually must junk their machinery when it wears out. At the very least, it is sold off at a nominal price and replaced with higher-productivity equipment, enabling producers to remain competitive in the face of technological progress. Industrial depreciation allowances are thus well justified, and rarely need to be offset by subsequent capital gains declarations. Real estate, however, is depreciated more than once, as a matter of course. Unlike other industrial assets, buildings that have been depreciated just once long run. Nevertheless, it is principally the location that becomes more valuable. Rising land values tend to more than offset any decline in building values. In practice, a significant portion of land appreciation tends often to be imputed to buildings, further expanding CCAs by allowing even land to be partly depreciated.25
25 Gaffney (1993).
Thus the putative
beneficiaries of cutting capital gains taxes — direct investors
— suffer
less from
high capital
gains tax rates than from the treatment of much of their capital gain as
ordinary income, which is taxed at higher rates. In real estate, on the
other hand,
depreciation effectively converts much of ordinary income to capital
gains. Whereas industrial investors pay tax on rising
investment in unsold inventories, even when no sales revenue is
received, real estate investors pay tax neither on rental income nor on
increases in property values as they accrue. The industry actually
receives cash income, but for tax purposes reports a cash loss. Because
real estate and manufacturing face such different cash flow tax
treatment, it is misleading to take the manufacturing industry as a
proxy for real estate in discussing the effect of cutting capital gains
tax rates.The greatest accounting distortion for the real estate industry occurs in the case of re-depreciation of buildings that already have been depreciated at least once. This redepreciation occurs following ownership transfers; the CCA is attached not to the physical asset, but to the change of ownership. As the building is resold at rising prices, investors are allowed to re-depreciate them again and again — and to write off these CCAs against their income, as if they were suffering an erosion of wealth. Thus, most capital gains in real estate represent “repeat gains” over unrealistically written-down book values. This accounting fiction enables real estate investors to continue indefinitely to take their income in the lightly taxed form of capital gains.26
26 Another kind of subsidy
occurs in the sphere of farm real estate. Speculation in farmland is
reflected in the high ratio of farm prices to gross receipts. This
suggests that, on the one hand, “gentleman fanning” occurs in
near-suburban areas as a means of minimizing property taxes (thanks to
the lower appraisals of land zoned for agricultural use), and on the
other hand, speculation in anticipation that the land subsequently will
be rezoned for commercial and residential
development.
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.Even when overall real estate values fell in the early 1990s, the IRS nonetheless recorded capital gains taken on properties built before the frantic price run-up of the late 1980s. Over a fifteen year period, the value of the building in our example might have been written down to near zero. If it were sold for just its original purchase price, the entire sales price of the building would be reported as a capital gain.
Although the 1981 depreciation giveaway was replaced by the 1986 revision of the tax code, buildings already under construction and about to come onto the rental market were grandfathered into the old code. Significantly, today these buildings have been fully depreciated and therefore are probably about to be sold, at least for book-keeping purposes — owners may buy their own buildings under different partnerships, or swap them for similar buildings with other owners. Their new owners can begin to depreciate them all over again, after duly paying capital gains taxes on the buildings’ increase over their near-zero book value. If they do not sell and re-depreciate their buildings, the owners will have to begin paying income taxes on their operating cash flow that hitherto was sheltered by depreciation allowances that have now run out. This lends a renewed note of urgency to the persistent campaign to cut capital gains tax rates.
Because excessive depreciation allowances favor real estate speculation relative to industrial production, they discourage new direct investment and employment. To reduce the capital gains tax — the only significant remaining source of federal revenue from real estate — would divert even more savings into the purchase and sale of existing buildings.
3. How Mortgage Debt Converts Rent into Interest
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.28
27 Balance Sheets for the US
Economy, Table L2, line 8.
28 “Business borrowers” do not include homeowners, but only non-corporate real estate partnerships and real estate corporations. Mortgage interest paid by homeowners is treated as a “consumer expense.”
28 “Business borrowers” do not include homeowners, but only non-corporate real estate partnerships and real estate corporations. Mortgage interest paid by homeowners is treated as a “consumer expense.”
3a.
Domestic Net Interest Paid by Business, in Billions of Dollars,
1929-1993
Source: NIPA
3b.
Domestic Net Business Interest: Percentage Compostion, 1929-1993
Source: NIPA
3c.
Net Business Interest, as Percentage of National Income
Source: NIPA
3d.
Components As Percentage of Total of Domestic Net Business Interest
Source: NIPAMost 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. In 1993 (the most recent year for which NIPA statistics are available) the real estate sector generated some $326 billion in interest payments, more than it contributed in income taxes and state and local property taxes together. Meanwhile, over the past half century, net declarable income plus capital consumption allowances and property taxes have been cut in half as a proportion of national income, from over ten percent to less than five percent. Thus interest is the real estate industry’s major cost, and as such, has helped to minimize the real estate industry’s income tax liability.
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.
In addition to paying interest to their bankers, real estate investors turn over the capital consumption portion of their cash flow as loan amortization payments. A major lesson from examining the NIPA accounts is that creditors have ended up with both the mortgage interest and the CCAs. Many investors operate at a nominal loss, and even on the margin of solvency, leveraging their properties to the hilt. Their hope is to ride the wave of increasing land values and “cash out” by selling their property for more than they paid. In pursuit of this opportunity to earn capital gains, they seek to control as much property as they can, and are willing to forego current income in return.
Sometimes, of course, no capital gains accrue. In some highly conspicuous cases, landlords have walked away from their properties, leaving their mortgage lenders holding the bag. This is what led to the $500 billion FSLIC bailout by the Reconstruction Finance Corporation. Many smaller real estate parcels likewise were abandoned in central city areas from New York to Los Angeles. Indeed, this process was part of an international phenomenon, extending from Canary Wharf in London to Tokyo’s Bubble Economy of 1985-1980. Nevertheless, holding onto properties by paying off their mortgage loans is made easier by favorable tax treatment. Indeed, nominal tax losses during 1984-91 enabled building investors not only to earn a rising cash flow, but to gain tax credits to shelter their otherwise taxable income earned in other sectors.
Real estate is pledged to mortgage lenders as collateral in case the promised interest payments fail to materialize. Capital gains have been collateralized into new and larger loans decade after decade, increasing the mortgage burden that transforms rental income and depreciation allowances into interest payments. Ultimately, the financial rentiers end up with most of the cash flow which landlords — and government tax collectors — relinquish.
Tax-deductibility of mortgage costs does not impair government revenues if mortgage lenders pay taxes on their interest income. Moreover, lenders may be able to shift part of the tax burden to borrowers by charging higher interest rates.29 Actually, however, much interest income manages to avoid taxation, such as that of banks adding to their loss coverage funds (or otherwise offsetting their income) or individuals with tax shelters. The insurance and financial industries have long obtained virtual tax exemption for their income.
29 Also, insofar as mortgage
interest is treated preferentially relative to other forms of interest,
there will be
XXXX — text missing
here, both the end of the footnote and the lead-in to the following
paragraph — and perhaps more.
immediately. Many take years of negotiation and litigation before they are paid out. In fact, the courts in many states are notoriously backed up by such litigation. Insurance company critics point out that by the time many companies actually pay out on their claims, the delays have saved them enough by deferment of income taxes to meet the entire cost. Also, pension funds and non-profits do not have to pay income taxes or capital gains taxes. (Non-profits include universities, which are major real estate investors.) Mutual funds have fewer tax breaks, but mutual funds for real estate typically are organized as real estate investment trusts (REITs), which often generate tax losses for their investors to charge against other income.
The result is that the FIRE sector as a whole has been subsidized at the expense of direct industrial investors and consumers. As Charts 4a, 4b, and 4c illustrate, compared to interest charges and property taxes, the reported $150 billion in rental cash flow is relatively small. Net taxable income is smaller yet. Just $24 billion in rental income (and an $86 billion cash flow) was reported by small building owners, that is, owners whose primary source of income was not real estate. $130 billion was earned by partnerships (the most common form of business organization in the real estate industry), while real estate corporations reported a $4 billion net loss (but a $3 billion net cash flow) in 1993.
4a.
U.S. Gross Real Estate Revenue, in Billions of Dollars, 1929-1993
Source: NIPA
4b.
U.S. Gross Rental Revenue as Percentage of National Income
Source: NIPA4c.
Components of Gross Rental Revenue as Percentage of Total Gross
Rental Revenue
Source: NIPA
Chart 5 tracks the relative growth of the finance, insurance, and real estate sector using Labor Department employment figures. It shows that what the classical economists called “productive” labor has remained constant since 1929, while virtually all growth has been in government (mainly state and local) and private sector services — mainly in the FIRE sector. Tax subsidies may largely explain why the FIRE sector has been the most rapidly growing part of the economy over the past half century. This is the conceptual context in which we should view the NIPA statistics.
| 5. Capital Gains As Reported to IRS - 1985, as Percentage of Total Capital Gains (Billions of Dollars) | ||
| Total
Capital Gains |
Estimated
Land Gain |
|
| Land | $16.4 | 100% |
| Business Real Estate & Partnerships | 41.2 |
80% |
| Rental Real Estate | 24.5 | 50% |
| Principal Residences | 39.5 |
40% |
| Corporate Stocks & Securities | 70.7 | 20% |
| Other Assets | 15.6 | 0% |
| Source: IRS | ||
4. Capital Gains Taxation in Real Estate
Tax rates on capital gains historically have been low compared to income tax rates (Table 1). Even more important is the fact that capital gains taxes are paid only at the time of realization, that is, when the asset is sold, not as the gains actually accrue. The longer a tax is deferred (and the higher is the imputed rate of interest), the lower is its discounted present value.
| Table 1. The Evolution of Capital Gains Tax Rates | ||||
| Maximum
Capital Gains Tax Rate (%) |
Top Marginal Income Tax Rate | |||
| Individuals | Corporations | Individuals | Corporations | |
| 1942-43 | 25% | 25% | 88% | 40% |
| 1944-45 | 25 | 25 | 94 | 40 |
| 1946-50 | 25 | 25 | 91 | 38 |
| 1951 | 25 | 25 | 87.2 | 50.8 |
| 1952-53 | 26 | 26 | 88 | 52 |
| 1954 | 26 | 26 | 87 | 52 |
| 1955-63 | 25 | 25 | 87 | 52 |
| 1964 | 25 | 25 | 77 | 50 |
| 1965-67 | 25 | 25 | 70 | 48 |
| 1968-69 | 25 | 27.5 | 70 | 48 |
| 1970 | 29.5 | 28 | 70 | 48 |
| 1971 | 32.5 | 30 | 70 | 48 |
| 1972-78 (Oct) | 35 | 30 | 70 | 48 |
| 1978 (Nov)-June ‘81 | 28 | 28 | 70 | 46 |
| June ‘81-86 | 20 | 28 | 50 | 46 |
| 1987 | 28 | 31 | 38.5 | 40 |
| 1988-89 | 33 | 34 | 33 | 34 |
| 1990-92 | 8 | 34 | 31 | 34 |
| 1993-95 | 28 | 35 | 39.6 | 35 |
| Source: American Council for Capital Formation, Center for Policy Research, “Update: Questions and Answers on Capital Gains,” Sept. 1995, based on Joint Committee on Taxation (1995), “Tax Treatment of Capital Gains and Losses,” JCW-95, February 13, 1995; and Office of the Secretary of the Treasury, Office of Tax Analysis (1985), “Report to Congress on the Capital Gains Tax Reductions of 1978.” | ||||
The effective rate is further reduced by numerous exclusions and exemptions. With regard to real estate, for example, homeowners enjoy a $125,000 exclusion for capital gains on sales of their primary homes, as long as they recycle the proceeds into buying a new residence within a year. Homeowners over 55 are permitted to sell their houses without having to pay any tax on their capital gain, as long as they buy a new residence of equal or higher value. The stated rationale for these concessions is that to tax residential capital gains would make homeowners pay taxes just to stay in the same economic position when they move to take new jobs in other cities or to retire. President Clinton’s recent proposal would further extend homeowners’ tax exclusions.
No capital gains duties are levied on estates passing to heirs. Indeed, inheritors of real estate may begin re-depreciating their income-yielding buildings afresh at the new (typically higher) transfer price. The estates bequeathed by the richest one percent of the population (over $600,000 in value) are now taxed at a 55 percent rate if not sheltered, but of course these are the estates most likely to shelter inheritance and gift bequests. For instance, assets given as gifts are taxed only at the time they come to be sold.30 If the capital gains tax were reduced or abolished, the deferral would become permanent.
Most capital gains reaped by business partnerships accrue to real estate firms, which shelter personal income by avoiding incorporation. IRS statistics ranking capital gains in terms of how long the assets were held show that many of these gains represent quick “flips." Often these are land that has been rezoned from a low-value to a high-value use. Retaining the capital gains tax would have little effect on deterring such speculation.
Properties held for longer periods of time by these partnerships typically are sold or swapped after having been fully depreciated. Swaps’ have long been permitted to the real, many almost perpetually free of income taxation. The logic for this loophole seems at first glance to be much like that for personal homeowners’ exemptions in selling a home to move somewhere else, without having to pay a capital gain tax in the process; but the analogy is specious. Homeowners cannot take a depreciation tax credit unless their property generates rental income, and most do not generate any income against which to claim CCAs31. In contrast, the capital gains which commercial real estate investors record for income-tax purposes are calculated, not merely on the gain in the property’s market price (as with owner-occupied homes), but on the excess of selling price over depreciated book value.
31 Homeowners do receive imputed
rental income, which is not subject to the income tax.
Major commercial real estate investors such as pension funds, insurance
companies and other large institutions are exempt from capital gains
taxes, as are foreign investors. In addition to playing a dominant role
in real estate, these institutional investors own nearly half of all
U.S. equities.3232 Minarik (1992), p. 20.
For similar reasons, Fazzari and Herzon note in a Levy Economics
Institute brief that “the ‘effective’ year-to-year tax rate on capital
gains (sometimes called the ‘accrual-equivalent’ tax rate) is actually
lower than the statutory rate."33 They
estimate the effective rate by halving the statutory rate to account
for the numerous exclusions and exemptions and then halving it again to
reflect the benefits of deferring taxes to the time capital gains are
realized rather than paying upon accrual. If this is correct, then for
today’s 28 percent capital gains tax, the first halving produces an
effective tax rate of 14 percent; the second reduces it to just 7
percent. To cut the (statutory) rate to 14 percent, as Senator Dole
proposed, would reduce the effective capital gains tax rate to roughly
3.5 percent.33 Fazzari and Hereon (1995).
5. Government Statistics on Real Estate Gains
- THE 1985 IRS SURVEY
34 Holik, Hostetter and Labate
(1989 and also 1990).
The IRS benchmark survey estimated 1985 capital gains at $208 billion, an amount equal to only 6.4 percent of that year’s $3.3 trillion national income. An analysis of how these capital gains were distributed as between land and buildings, plant and equipment, other direct investment, and the stock market indicates that the economy's capital gains are mostly in real estate, and in greater proportion than the IRS benchmark study suggests. For properties sold during the year, including the values embodied in stock-market equities, we interpret the IRS survey as suggesting land value gains of about $97 billion (Chart 6). This does not include institutional or foreign real estate holdings, for these are not subject to taxation and thus were excluded from the IRS sample. The IRS statistics show only what individual persons who sold assets in 1985 were declaring on their tax returns. Table 2 tracks land gains as a percentage of total reported capital gains for the 1985 IRS data.
Within these limitations of scope, sales of principal residences35 totaled $37 billion, accounting for 19 percent of the capital gains sample. However, the statistics were swamped by the $125,000 exclusion for capital gains on safes of owner-occupied homes. This exclusion was so large, coming as it did just as the real estate bubble was peaking, that it reduced the proportion of taxable capital gains accounted for by residential sales from 19 percent to just 1.1 percent of the sample.
35 Reported on Form 2 119.
| 6. National Income Plus Capital Gains In Land - 1985 in Billions of Dollars | ||
| Total Land and Other Natural Resource Gains (Estimate) | $500 | |
| Federal Reserve Estimate | $167 |
Capital
Gains
|
| IRS Reported Capital Gains (l/20 of All Land Held) | $92 | |
| combined |
$259 | |
| Gross Rent |
$452 | |
| Other National Income |
$2,606 | |
| Total National Income | $3,058 | |
| Source: NIPA, IRS | ||
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.
36 See Chart 6 for the
assumptions made as to the IRS breakdown of capital gains, by industry.
This estimate closely approximates the Federal Reserve’s statistics for
land
and real estate improvements as a proportion of the US economy's net
assets.
- THE FEDERAL RESERVE DATA
Federal Reserve Board statistics considerably outstrip the 1985 IRS
estimate of $208 billion of taxable capital gains. The Fed’s Balance
Sheets for the U.S. Economy lists the total value of land, buildings
and other real assets. For produced capital, the annual increase in
aggregate asset values does not distinguish capital gains on existing
assets from the value of new production. For land, however, the value
of new production must be zero, so the entire annual increase
constitutes capital gains — accurately, land gains. According to the
Fed,
aggregate building values increased by $204 billion in 1985, while land
prices rose by $356 billion, more than three and a half times the value
implied by the IRS statistics.
The Federal Reserve Board provides an implied estimate of land gains
(and a measure of building gains that does not include
over-depreciation pay-backs recorded fictitiously as capital gains) in
its Z9 release estimating asset values throughout the economy. However,
the IRS and Fed are not measuring capital gains in the same way. The
Fed measures the overall nationwide market value of land and buildings,
while the IRS sample includes only properties sold
during the year. Furthermore, the IRS statistics do not include capital
gains on which no taxes are due because of exclusions.
On the other hand, the Fed statistics37 understate
land values for methodological reasons. Starting with estimates for overall
real estate market prices, Fed statisticians
subtract estimated replacement prices for existing buildings and
capital improvements to derive land values as a residual. These
replacement prices are based on the Commerce Department’s index of
construction costs. Thus, building values are estimated to increase
steadily over time, on the implicit assumption that all such property
is worth reproducing at today’s rising costs.
37 Balance Sheets for the U.S.
Economy, 1945-94, Tables B. 11, B. 12 and R 11.
However, the value of any building tends eventually to decline, until finally it is scrapped and replaced. It is the value of land which tends to rise as population and income grow (over the long run, with cyclical swings), precisely because no more land can be produced. Thus, capital gains in real estate result mainly from land appreciation.
Building values fall because of physical deterioration, but also because buildings undergo locational obsolescence as neighborhood land uses change over time, so market prices tend to fall below replacement costs. It would not be economical to rebuild many types of structures on the same site if they were suddenly destroyed.38 In particular, where land use is intensifying over the long run, rising land values effectively drain the capital value out of old buildings. This is because the salvage value of land (its worth upon renewal) tends to rise, while the scrap or salvage value of most immovable improvements is negligible. Where land has alternative uses, rent is not its current net income but its opportunity cost — the minimum yield required by the market to warrant keeping the land in its present use instead of converting it to the best alternative use. As the land value rises, a rising share of the property income must be imputed to the land and a falling share remains to be imputed to the improvements.39
38 Sometimes, to be
sure, there is a renaissance, as when gentrification occurs. Land use
is currently
being shifted away from industry to residential development in the
center of cities much the same way that it is being shifted away from
agricultural uses to residential development at the outer margins of
cities. However, gentrification comes because entire industrial areas
have lost their value. In New York, it occurred in the Tribeca and Soho
neighborhoods in southern Manhattan resulting in more than 10,000
residential loft conversions during the city’s economic downturn in
the 1970s. In Chicago, it occurring west of the Loop, and on the Near North
Side.
39 Indeed, where ill-maintained old buildings occupy prime locations, a parcel may be more valuable once the building is demolished and the lot cleared for reuse See Gaffney (1993 and also 1971). Some improvements, such as gas stations and refineries, are accompanied by ecological pollution, which can be analyzed as a negative improvement — the property would be worth more without it. Pollution may greatly increase the saIvage cost of land making it uneconomical to salvage some lands despite the value they would have if clean. This “brownfields” problem has received considerable public notice in recent months.
Thus, the correct way to separate land values from building values is
to appraise land values directly in terms of opportunity cost — how
much
would a vacant lot at that site fetch in the market? If the observed
market value of the improved property exceeds the land value, the
residual is the implied value of the standing improvements. The Fed’s
land-residual method theoretically understates the land share of real
estate values.40 The
pitfall of this methodology is demonstrated to an almost comical degree
by the fact that according to Fed statistics, the land component of
corporately owned real estate has been reduced to near zero over the
past five years (while the nominal reproduction costs of factories and
other corporately held buildings are inflating).39 Indeed, where ill-maintained old buildings occupy prime locations, a parcel may be more valuable once the building is demolished and the lot cleared for reuse See Gaffney (1993 and also 1971). Some improvements, such as gas stations and refineries, are accompanied by ecological pollution, which can be analyzed as a negative improvement — the property would be worth more without it. Pollution may greatly increase the saIvage cost of land making it uneconomical to salvage some lands despite the value they would have if clean. This “brownfields” problem has received considerable public notice in recent months.
40 Gaffney (1993).
The measurement problem is exacerbated by assessment bias in many states and localities. Particularly where land values are trending upward, overestimates of building values relative to site values reflect the steady under-assessment of land. Note that as a larger share of real estate value is imputed to buildings, a larger share of cash flow can be claimed as depreciation. In effect, assessment bias allows investors to partly depreciate land, at no cost to local government budgets.41
41 Studies cited by
Gaffney (1993) of assessed building values at
demolition indicate a tendency of assessors, too, to overvalue
depreciable improvements. At the moment of demolition for example, a
building’s value equals its scrap value (if any) minus the cost of
demolition. The result can easily be negative. That is, the cleared
land may be worth more than the parcel is worth with the old building
standing and its cleanup costs yet to be borne. The IRS may question
specific building appraisals, but the general practice is to accept the
local city assessment, which tends to favor buildings over land It is
well known that Fed statistics on the value of corporate land and
buildings show an unrealistic low valuation of land.
Official statistics should provide a sense of proportion as to how the economy works. Especially when it comes to real estate, however, national income statistics tend to obfuscate more than they reveal. They are the product of income-tax filings, and hence are distorted for both administrative and political reasons; they do not reflect fundamental categories of economic analysis. One searches in vain, for example, for an estimate of the distribution of total income among land, labor, and capital, or for an accounting of how rentier claims on revenue and output are layered upon directly productive enterprise.
6. The Political Context of Real Estate Taxation
Much of the public discussion of capital gains policy has been conducted with little reference to empirical research as to their actual character and composition in the US economy. Capital gains, and savings in general, are defended on the assumption that they are automatically transformed into new direct investment. Yet the more layers has the debt pyramid, the smaller is the proportion of savings used to finance direct investment. Moreover, our investigation suggests that a large and expanding share of the economy's capital gains — as they are defined, measured and taxed — has little discernible impact on net investment or employment.
IRS estimates of capital gains measure only the small proportion that individuals are obliged to declare after all the exemptions and exclusions have been utilized. There is no estimate of the volume of capital gains generated each year, and no adequate breakdown as to where these gains occur. This statistical lacuna means that the economic cost of assorted tax loopholes is not being calculated. There is no sound statistical basis for calculating the total returns being taken by investors, or the proportion of those returns paid in taxes.
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.
Academic economists likewise have been remarkably slow to address this shift away from earned income to capital gains. It is true that nineteenth-century land reformers such as John Stuart Mill and Leon Wahas defined land-value gains as an “unearned increment,” and urged that they be collected by the community at large, whose economic activity was, after all, responsible for creating these gains. Ever since Henry George brought matters to a head in Progress and Poverty (1879), however, economics has largely dropped the analysis of land-value gains, and indeed, of land itself42
42 Gaffney and Harrison (1994).
Wealthy investors have won congressional support for real estate exemptions in large part by mobilizing the economic ambitions of homeowners. Most families’ major asset, after all, is their home. Two Federal Reserve studies trace the rise in gross house value from 26 percent of household wealth in 1962 to 30.1 percent in 1983 (falling back to 28.5 percent in 1989).43 Household real estate assets substantially exceeded holdings of stocks, bonds and trust funds (20.5 percent in 1989), liquid assets (17 percent) and total debt (14 percent).44 The giveaway to real estate interests is thus presented ostensibly as a popular middle class measure. The real estate industry (and the financial sector riding on its shoulders) have found that the middle classes are willing to cut taxes on the wealthy considerably, as long as their own taxes are cut even lightly. It is no surprise that President Clinton’s first major concession to the pressure for cutting capital gains taxation is directed at homeowners, despite the fact that preferences for home ownership cannot be justified as a boost to entrepreneurial investment. Such is the foreshortened economic perspective of our times.
43 1962 Survey of Financial
Characteristics of Consumers, and its subsequent Survey of Consumer
Finances for 1983, 1986, 1989, and 1992.
44 Details are reported in Bureau of the Census (1988).
44 Details are reported in Bureau of the Census (1988).
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.
45 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.7. Policy Conclusions
Because real estate investors make much of their money by buying and reselling existing properties, much as financial investors buy already seasoned stocks and bonds, many real estate and stock transactions have no new employment or direct investment effects regardless of the capital gains incentives being offered. Yet the tax code permits real estate investors to take their returns mainly in the form of capital gains and declare little taxable ordinary income. FIRE sector investors in the finance and insurance industries also have taken their income in ever more lightly taxed forms. These tax subsidies divert effort and ingenuity out of productive channels and into speculation on already existing buildings and land, or already issued stocks and bonds. An across-the-board cut in capital gains taxes would favor the FIRE sector rather than manufacturing, steering investment money further from active to passive investment. Far greater stimulus to productivity is to be expected from, instead, eliminating special privileges and closing loopholes — while reducing taxes on payrolls, sales, and enterprise.
Adam Smith and subsequent classical economists defined some forms of investment and income as being more productive than others, suggesting a normative basis for evaluating legislation on the basis of economic efficiency and productivity. Although there was disagreement as to details, it was the essence of classical political economy to distinguish productive from unproductive investment. Productive investment added to revenue, employment and wealth. Unproductive investment, what today would be called zero-sum transactions, merely redistributed income.
The classical economists distinguished the earned income of capital and labor from what they deemed unearned income, mainly in the form of land rent and, by extension, the rent of public monopolies as well as mines and other natural resources. They applauded industrial profits and other returns to the factors of production; they frowned on the rentier takings that burdened productive effort. Profits, they believed, tended to be recycled into new investment, employing yet more labor to increase output, while rentier income was a kind of economic overhead. A fundamental problem was the tendency of rent to be dissipated on consumption expenditures to maintain the rentier lifestyle, for example, to support a retinue of servants who absorbed income rather than generating new growth in revenue. The industrialists, by contrast, tended to recycle their revenue back into new capital formation. By the time of John Stuart Mill, the mainstream of British political economy defined “capital gains” in land and real estate as economically sterile.
Thus the classical view of economics was no law of the jungle. It endorsed an institutional shaping of the market place so that economic self-interest would serve society’s long-term objectives. Self-interest was the mainspring, but just as every watch needs controls and release ratchets, self-interest had to be harnessed in service to the general welfare and steered away from unproductive or corrosive activities.
The after-tax earnings of labor and enterprise constitute incentives for markets to expand economic horizons. They generate more taxes in the process, as well as more wealth. Such is not the case with forms of wealth appropriation that constitute zero- or negative-sum transfers from consumers, workers and other taxpayers to corporate raiders, privatizers, real estate speculators or outright crooks.
Two Republican presidential hopefuls, Steve Forbes and Lamar Alexander, sought unsuccessfully to win voter support in the primaries by advocating a flat-rate tax with just a few exceptions. The exceptions were mortgage interest — on the ground that taxing it would reduce the value of much of the nation’s real estate, by forcing some strapped homeowners to sell — and capital gains. Yet these are two of the most parasitic ways of getting rich. Bank credit was distorted throughout the 1980s, away from financing real estate trades in preference to direct industrial investment and employment. Speculators borrowed money to buy buildings, agreeing to pay their rental income to the banker (or S&L, insurance company or other mortgage lender) at the taxpayer’s expense.
Taxation of capital gains is widely attacked as a “soak the rich” scheme, a program of wealth redistribution that will adversely affect growth in productivity and efficiency. Kurt Hauser’s Wall Street Journal editorial counters this with the observation that over half of all taxpayers reporting capital gains have adjusted gross incomes of under $50,000, implying that a tax cut would not preferentially benefit the wealthy. He neglects to observe, however, that the poorer half of taxpayers account for less than ten percent of the total dollar value of capital gains46 — or that the capital gains tax is virtually the only remaining federal levy on real estate income. Low capital gains tax rates and the tax deductibility of mortgage interest have contributed to the polarization of wealth distribution. A further reduction in the capital gains rate would worsen this maldistribution by making real estate virtually tax-free except for local property taxes, which fell from 10 percent to just 7.4 percent of all taxes at all levels of government between 1955 and 1989.47
46 Hauser (1995); Wolff (1995).
47
Rosen (1992), p. 22.
Time columnist John Rothschild recently accused opponents of a capital gains tax cut of resisting “any reform, no matter how it may benefit society in general,” simply “so that the rich cannot benefit."48 The implication is that any resulting growth in income inequality is the price a free society must pay for an efficient system of economic incentives. Indeed, it would be difficult to oppose widely shared progress simply because the rich are gaining faster than the rest of society. The point, however, is that the tax code encourages the wealthy to enrich themselves in ways that are detrimental to the economy at large. The presumed trade-off between equity and efficiency is mythical, at least with respect to real estate under the current federal tax code.
48 Rothschild (1995).
An inordinate focus on stock market gains — especially the selection
of small industrial companies such as a yacht producer just making his
first stock offering — diverts attention from the extent to which a
low capital gains tax benefits real estate investors preferentially.
The irony of casting the issue in terms of the stock market rather than
real estate investment is that financial investors have already devised
an array of strategies to evade taxation on stock gains. Institutional
investors already are exempt from capital gains taxes on securities, as
they are on their real estate holdings. Wealthy individual investors
can arrange fictitious “short” sales (“sales against the box”),
obtaining the proceeds of their stocks without having to actually sell
them, by collateralizing them with a bank and borrowing an amount of
money equal to the value of the stocks. This is the equivalent of a
sale, for it provides immediate proceeds — but without incurring taxes
on the securities’ rise in value. Bankers find this a lucrative
business, while the Treasury foregoes revenue at the expense of less
affluent taxpayers. To abolish capital gains taxes would enable these
fictitious “against the box” maneuverings finally to be liquidated
without having paid any taxes. Also freed would be the accumulated
over-depreciation of buildings that has sheltered past real estate
income.If the intention is to provide an incentive for new direct investment, employment, and industrial modernization, then an across-the-board capital gains tax cut is at best a blunt policy instrument. We have examined several reasons to doubt that further cuts in capital gains taxes will have a pronounced incentive effect on new direct investment.49 Capital gains tend to reward accumulation of old assets more than production of new wealth. The stock market is mostly a second-hand market, but we do not lean too hard on this point because the (discounted) anticipation of future capital gains may boost the demand for new stock issues, making it somewhat easier for corporations to finance new investment. The main point is that most taxable capital gains represent appreciation of non-produced land and of structures built years ago. In the current institutional setting, real estate gains are artificially inflated by generous depreciation rules, which apply not only to newly constructed buildings but also to second-hand buildings and even, effectively, to land, which neither depreciates nor is replaced. As long as these and other rules are in place, an across-the-board capital gains tax cut will preferentially benefit real estate and financial speculation at the expense of industrial production. It will also increase the federal budget deficit, ultimately at the expense of lower- and middle-income taxpayers.
49 A capital gains tax
cut may relieve a lock-in effect caused by
taxing capital gains upon realization instead of accrual. However,
Gaffney (199 l), p. 50, writes that “the locked-in effect results
mainly from stepup at death, rather than from a high rate per se.”
One reason often cited for taxing capital gains at lower rates than ordinary income is to exempt “phantom income” arising from inflation. The logic of indexing is that if prices rise by, say, 50 percent between the time of purchase and the time of sale, then this amount should not be taxed; to do so would be to tax investors just for “staying in place.” However, inflation erodes all monetary assets, not just capital gains,50 and may erode the purchasing power of labor income, as has occurred for most wage-earners in recent years. Equity in the face of inflation is thus a poor argument for preferential capital gains tax rates.
50 Gaffney (1991), pp. 49-53. Inflation amounts to a general wealth tax.
Four conclusions for federal tax policy are summarized below, ranked in ascending order as to the confidence with which we offer them.
- DO NOT REDUCE CAPITAL GAINS TAXES ON BUILDINGS.
- DO NOT PERMIT BUILDINGS TO BE DEPRECIATED MORE THAN ONCE.
As long as capital consumption allowances give the real estate industry a peculiarly generous income tax status, real estate investors will do what they can to impute an excessive proportion of total real estate value to depreciable improvements.51 Moreover, as long as real estate income is effectively exempted from the income tax, a powerful lobby will continue the drive to substitute income taxes for state and local property taxes.52
51 Local assessors frequently
appear to act in collusion with
landowners: Gaffney (1993).
52 An ad valorem tax on land values would recapture that part of the real estate value which is created by the surrounding community. While taxes on produced wealth tend to discourage the reproduction of such wealth, well-administered taxes on the market value or annual rent of land are among the least intrusive forms of taxation. They generate no “excess burden of taxation” and discourage neither the production nor the economic use of land (Tideman, 1994, p. 135). They reduce the incentive to speculate, and induce more intensive use of valuable lands. They cannot be shifted to tenants or consumers, and they do not erode their own tax bases. Both efficiency and equity are therefore well served by focusing taxes on land values. High land taxes would also help counter the widespread tendency to over-assess buildings (and hence, to increase their permitted CCA) relative to land
52 An ad valorem tax on land values would recapture that part of the real estate value which is created by the surrounding community. While taxes on produced wealth tend to discourage the reproduction of such wealth, well-administered taxes on the market value or annual rent of land are among the least intrusive forms of taxation. They generate no “excess burden of taxation” and discourage neither the production nor the economic use of land (Tideman, 1994, p. 135). They reduce the incentive to speculate, and induce more intensive use of valuable lands. They cannot be shifted to tenants or consumers, and they do not erode their own tax bases. Both efficiency and equity are therefore well served by focusing taxes on land values. High land taxes would also help counter the widespread tendency to over-assess buildings (and hence, to increase their permitted CCA) relative to land
- DO NOT REDUCE CAPITAL GAINS TAXES ON LAND.
53 Macro-developments where
developers build entire towns or
neighborhood enclaves are sometimes understood to increase land rent in
the sense that they internalize
location externalities; this may reflect inconsistency in the
definition of a land parcel for assessment
purposes (Feder, 1993, pp. 83-105). Most such cases are urban or
suburban redevelopments that involve large
public subsidies, with public land turned over at concessionary prices
and with generous tax abatements
(of-ten to large institutional investors who are politically
well-connected).
54 Feder (1994), p. 146-148.
55 Gaffney (1989); see also Gaffney (1993).
54 Feder (1994), p. 146-148.
55 Gaffney (1989); see also Gaffney (1993).
- IMPROVE THE QUALITY OF STATISTICS AND REFORM NIPA ACCOUNTING PRACTICES.
Presently, US statistics appear to undervalue land by at least a trillion dollars (at about $4 trillion, down from the $5 trillion estimated in 1990). The Federal Reserve method of calculating land and improvement values by estimating a building’s reproduction cost is inappropriate. The market value of land should be evaluated independently, rather than derived by subtracting the hypothetical replacement cost of buildings from market real estate values. The theoretically correct approach is the building-residual method of real estate assessment, as we noted in Section 5. One result of consistently applying the building-residual method would be to raise the land share and lower the building share of assessed property value, and thus narrow the depreciation loophole.56
56 Gaffney (1993). Also, land
and buildings are frequently assessed
in a scattershot pattern, with land for contiguous
parcels showing abrupt drop-offs or jumps. An entire
profession of appraisal litigators has arisen; lawyers
can get their clients’ property taxes reduced simply by
finding some seemingly similar low-valued properties.
Such practices contribute to sharply under-valuing land in
many areas. To overcome this administrative problem,
smooth, continuous land value maps should be
created using geographic information systems computer
technology, and should be continuously
updated using land sales data. More frequent
reassessment, especially in areas with rapidly appreciating
land values, would tend to increase property tax
revenues and probably also to increase the land share of
the total assessment.
It can only confuse matters to debate capital gains taxes without
separately considering three major sources: real estate as the
economy's largest
recorder of capital gains (separable in turn into land and
improvements); other direct
capital investment; and financial claims on the income generated by
this capital (stocks,
bonds, and packaged bank loans that are “securitized”). In the real
estate sector, most “capital
gains” in the colloquial sense of rising market prices accrue to land,
but IRS statistics mainly
catch the landlord’s fictitious declaration of the loss in building
values through
over-depreciation. The present GNP/NIPA format fails to differentiate
carefully among land, produced
wealth, and financial claims.
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.
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