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Rev. A. C. Auchmuty: Gems from George, a themed collection of excerpts from the writings of Henry George (with links to sources)
Fred Foldvary: Geo-Rent: A Plea to Public Economists
For private lands, much of the revenue from geo-rent is hidden in interest payments, corporate profits, and capital gains, implying that it isn’t showing up in “rental income of persons.” For example, the way that building-owners may treat “depreciation” is unrealistic and even nonsensical. Suppose Bob buys a building for $275,000 (excluding the land value) and rents it out for $40,000 per year. On the premise that a building is used up in 27.5 years, the tax code allows him to deduct $10,000 each year. And then he deducts his real expense (maintenance, etc.) of, say, $5,000, so the column shows only $25,000 in rental income. Suppose that after 27.5 years, Bob sells the building to Sam. Now Sam starts deducting depreciation all over again. Capital consumption is to a large degree a legal fiction. Read the entire article
Many economists rely on data generated by the IRS, taken from tax returns, to tell them the sources of income in the U.S. This is an exercise in crediting bad data. The standard tax procedure of landlords is to deduct alleged “depreciation” from their net operating rents (“cash flow”) to arrive at taxable rents. They accelerate depreciation enough, usually, to report little or no taxable rent. This is what the IRS then aggregates and reports as the sum of all rents. To accept such fiction as fact is inexcusable, but economists do it anyway. Their credulity lends their authority to the IRS, while the IRS “official” status helps legitimize the economists -- mutual validation of mutual error, the curse of science.
When owner A has exhausted his tax “basis” by overdepreciating, he sells to B for a price well above the remaining basis. B then depreciates the same building all over again, then sells to C, who sells to D, and so on, so each building is tax-depreciated several times during its economic life. In any given year, most income properties in the U.S.A. are being tax-depreciated, even though most have already been depreciated once or more.
In addition, all owners after the original builder are in a position to depreciate some of the land value, as well. This is because the owners control the “allocation of basis” between depreciable building and non-depreciable land. The IRS has no defense against secondary owners who overallocate value to the depreciable building. Congress has never authorized the IRS to develop any in-house capacity to value land. The most the agency does, if it will not accept the word of the tax filer, is to look at allocations used by local assessors. These parties, in turn (with a few notable exceptions), underassess land relative to buildings, by using the erroneous “land-residual” method of dividing land from building value. This is partly to accommodate their local constituents - assessors are locally elected or appointed, and do not report to the IRS. A little math will tell you that to depreciate land just once is to achieve perpetual tax exemption. To depreciate it again and again is a continuing subsidy for holding land.
When A sells to B there is a large excess of the sales price over the remaining or “undepreciated” basis. This excess is, to be sure, taxable income. However, Congress has defined this kind of income as a “capital gain.” Most rents, therefore, show up as capital gains. These, in turn, are subject to lower tax rates, deferral of tax, forgiveness at time of death, constant pressure to lower rates to zero, and a dozen additional avoidance devices. These are known to every lawyer and accountant and Congressman, but not, apparently, to most economists, who lazily report from “official” data that rents are a low fraction of national income. Read the whole article
Turning land-value gains into capital gains
Hiding the free lunch
Two appraisal methods
How land gets a negative value!
Where did all the land value go?
A curious asymmetry
Site values as the economy's "credit sink"
Immortally aging buildings
Real estate industry's priorities
THE FREE LUNCH Its cost to citizens Its cost to the economy
Turning land-value gains into capital gains
YOU MAY THINK the largest category of assets in this countrly is industrial plant and machinery. In fact the US Federal Reserve Board's annual balance sheet shows real estate to be the economy's largest asset, two-thirds of America's wealth and more than 60 percent of that in land, depending on the assessment method.
Most capital gains are land-value gains. The big players do not want their profits in rent, which is taxed as ordinary income, but in capital gains, taxed at a lower rate. To benefit as much as possible from today's real estate bubble of fast rising land values they pledge a property's rent income to pay interest on the debt for as much property as they can buy with as little of their own money as possible. After paying off the mortgage lender they sell the property and get to keep the "capital gain".
This price appreciation is actually a "land gain," that is, it's not from providing start-up capital for new enterprises, but from sitting on a rising asset already in place, the land. Its value rises because neighbourhoods are upgraded, mortgage money is ample, and rezoning is favorable from farmland on the outskirts of cities to gentrification of the core to create high-income residential developments. The potential capital gain can be huge. That's why developers are willing to pay their mortgage lenders so much of their rent income, often all of it.
Of course, investing most surplus income and wealth in land has been going on ever since antiquity, and also pledging one's land for debt ("mortgaging the homestead") that often led to its forfeiture to creditors or to forced sale under distress conditions. Today borrowing against land is a path to getting rich -- before the land bubble bursts. As economies have grown richer, most of their surplus is still being spent acquiring real property, both for prestige and because its flow of rental income grows as society's prosperity grows. That's why lenders find real estate to be the collateral of choice.
Most new entries into the Forbes or Fortune lists of the richest men consist of real estate billionaires, or individuals coming from the fuels and minerals industries or natural monopolies. Those who have not inherited family fortunes have gained their wealth by borrowing money to buy assets that have soared in value. Land may not be a factor of production, but it enables its owners to assert claims of ownership and obligation, i.e., rentier income in the forms of rent and interest. ...
Hiding the free lunch
BAUDELAIRE OBSERVED that the devil wins at the point where he convinces humanity that he does not exist. The Financial, Insurance and Real Estate (FIRE) sectors seem to have adopted a kindred philosophy that what is not quantified and reported will be invisible to the tax collector, leaving more to be pledged for mortgage credit and paid out as interest. It appears to have worked. To academic theorists as well., breathlessly focused on their own particular hypothetical world, the magnitude of land rent and land-price gains has become invisible. But not to investors. They are out to pick a property whose location value increases faster rate than the interest charges, and they want to stay away from earnings on man-made capital -- like improvements. That's earned income, not the "free lunch" they get from land value increases.
Chicago School economists insist that no free lunch exists. But when one begins to look beneath the surface of national income statistics and the national balance sheet of assets and liabilities, one can see that modern economies are all about obtaining a free lunch. However, to make this free ride go all the faster, it helps if the rest of the world does not see that anyone is getting the proverbial something for nothing - what classical economists called unearned income, most characteristically in the form of land rent. You start by using a method of appraising that undervalues the real income producer, land. Here's how it's done.
Two appraisal methods
PROPERTY IS APPRAISED in two ways. Both start by estimating its market value. The land-residual approach subtracts the value of buildings from this overall value, designating the remainder as the value of land. ... The building-residual approach starts by valuing the land, and treats the difference as representing the building's value. ...
IF THE APPRAISAL controversy is framed in terms of business cycle analysis, then the statistician finds no reasonable alternative to seeing that when the cycle rises and falls, the difference must be in the land, not buildings. What people are buying are not reproduction costs, whose fluctuations over the course of the credit cycle are relatively minor. They are buying site value, which is in limited supply, akin to a natural monopoly. Most of all, real estate investors and homeowners are buying the right to resell their property as prices are bid up by what they expect to become an increasingly affluent economy fuelled by an abundant supply of mortgage credit.
The land-residual approach appears to work as long as a fairly constant proportion of land to buildings is maintained. Statistically, this can occur only when property prices are rising at about the same rate as commodity prices and wages. But business cycles snake around the economy's basic trends, rising steadily and then plunging sharply. This fluctuation is what causes the most serious problems for statisticians.
In a thriving real estate market appraisers typically use a rule of thumb in allocating resale prices as between land and buildings to reflect their pre-existing proportions. Buildings typically are assumed to account for between 40 percent and 60 percent of the property's value. As a result, building values are estimated to grow along with a property's overall sales value. This appraisal practice is made to appear plausible as the pace of asset-price inflation tends to go hand in hand with rising construction costs, and hence in the theoretical replacement cost of buildings.
As noted, the anomaly occurs when real estate prices fall. Real estate prices are volatile, while construction costs rarely dip more than slightly, if at all. When real estate prices turn down, they often plunge below the reproduction cost of buildings. Hence, the residual ("land") rises and falls much more sharply than do building replacement costs (which are estimated as rising at a fairly steady pace) and overall property values.
The result is a curious asymmetry. Building prices seem to be responsible for the rise in real estate prices, while land prices are held responsible for their decline. When the fall in property values intersects the rising reproduction-cost trend, the land residual turns negative. ...
Immortally aging buildings
INCOME TAX LIABILITY may be minimized in two ways.
This fiscal privilege has created a phantom real estate economy. Buildings acquire death-defying lives, metamorphosing time and again for the purpose of enabling their owners to avoid paying income taxes. For commercial real estate investors as a whole, the repeated depreciation of buildings has made commercial real estate investment largely exempt from the income tax. Homeowners are not permitted to charge depreciation on their own residences, but only on buildings that they rent out.
The tax laws governing depreciation thus turn largely on how much value is assigned to buildings relative to the land, which is not depreciable. Like manufacturers, real estate owners are permitted to count part of the revenue over and above their current expenses as a return of their capital investment, as distinct from taxable earnings on capital. No income taxes are levied on this part of their revenue. That is only fair, because an investor who buys a $100 bond only pays tax on the interest, not on the original $100 principal. Likewise, industrialists can recover their initial investment in plant and equipment without being taxed. Their "sunk cost" gets reimbursed, so that they get their capital back by the time the equipment wears out or becomes obsolete.
For real estate, however, the economics are unique. Machinery rarely can be re-depreciated, but this is not true of buildings as long as they are kept in proper repair. Maintenance and repairs typically consume about 10 percent of the rental value. For business owners, the explicit purpose of this expenditure is to maintain the building's value intact, so that it can survive year after year and avoid obsolescence while its site value rises. If a building is sold at a higher price, its assessment usually is raised. Suppose a property is sold for twice the $1 milliuon the owner paid for it. The local appraiser is likely to say; "I see you've sold your building for $2 million. Under my rule of thumb, I appraise the land as half this value, and the building as half, so that gives you a $1 million dollar building." Under this rule, the building that was formerly priced at $500,000 can be re-depreciated at a price that builds in this $500,000 gain. In this way a substantial portion of the rise in site value of non-depreciable land is treated as depreciable building value.
THE FREE LUNCH: Its cost to citizens
The recycling of savings into new mortgage lending has fueled an economy-wide inflation of asset prices for land, homes, and commercial properties, as well as stock market and bond prices. If what rises in value is mainly the land site, then the property owners appear as passive beneficiaries enjoying a free lunch. The property is their major asset and the mortgage their major debt. While doing little to increase the value of the building beyond having picked a good location and making the normal maintenance, they ride the crest of asset-price inflation of land . Indeed, take-home earnings have drifted down over the past two decades, but house prices have soared.
These "capital gains" for households are part of the new phenomenon that has been popularized as "labor capitalism." As Margaret Thatcher's crowd has put it, "Sorry you've lost your job; I hope you've made a killing on your Council House or home in the real estate market." The free lunch.
For the two-thirds of America's and Britain's populations who are home owners, this free lunch from asset-price inflation of land has proved to be a silver lining in the post-industrial economy. For the remaining third of the population, however, the price of access to home ownership is receding rapidly. Today it hardly is possible for most renters to earn the money to acquire their own homes. The entry price has been bid up too high by those hoping to gain from asset-price inflation even as labor's earnings have been declining.
Its cost to the economy
Once a building has taken all its depreciation, investors have a tax motive to sell the property and buy another. The sales price obviously will be higher if the new buyer can begin depreciating the building all over again, for the property will yield more after-tax revenue. This financial trick turns the real estate sector into a game of musical chairs, while enabling property owners to avoid income taxation. The end result is to free more of their cash flow to pledge to mortgage lenders as interest, in exchange for loans to buy more and more property that is rising in price. This is the anatomy of the dramatic increase in land-prices, called the real estate bubble. The tragedy of modern economies is this divergence of saving away from financing new direct investment and employment, to inflate a financial and real estate bubble. When the bubble bursts there will be little new tangible wealth creation to show for it, only a wave of insolvency, bankruptcy and foreclosures as the Western economies begin to look more like that of Japan since its bubble burst a decade ago. America's and Europe's largest economic expansion may similarly give way to a long depression. Its cause will remain invisible as long as the politically powerful real estate interests keep getting land undevalued and its income masked as capital gains on the national income and product accounts
For hundreds of years property's value has been calculated by discounting its flow of rental income at the going rate of interest. The lower the interest rate, the higher the price a given rental stream will justify -- or as property owners express it, the more years' rent a property will bring. What is so striking about land values today is that they are rising for reasons independent of their earnings stream. The major new consideration is their prospect for future "capital" (that is, land-price) gains. In sum, the ultimate aim of real estate investors no longer is so much to seek income -- most of which is pledged to their bankers as interest payments on the property they acquire -- as much as to seek property gains. Politically opportunites abound. Merely changing zoning in New York City in the 1980s to allow using commercial loft spaces for residential purposes had the effect of multiplying asset values five or tenfold.
Whether the gains come from selling the property or from borrowing more money against it, the essential phenomenon is the rapid growth in asset values and real estate's uniquely favored tax treatment. That's why investors choose real estate instead of bonds or stocks, and much of the strategy underlying corporate takeovers has followed the strategies they developed over the past half century.
Nationwide the capital-gains dimension needs to be incorporated into the rental revenue statistics to measure real estate's total returns. This sector's nearly complete success in escaping the tax collector has placed an enormous tax burden on everyone else. Read the whole articleMichael Hudson and Kris Feder: Real Estate and the Capital Gains Debate
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. Read the whole article
Mason Gaffney: Land as a Distinctive Factor of Production
Land income is much greater than the current cash flow
The income of depreciable capital is cash flow less depreciation. The income of appreciable land is cash flow plus appreciation. That is quite a difference.
With land held for appreciation there is no cash flow to disclose the high values and the steady accrual of gains in wealth. This quality of "silent accrual" is found in land surrounding cities, or growing retail centers, as well as in land considered potentially mineral-bearing. Other land is valued for expected higher future cash flows in its present use, or some higher use to come. Some land is valued for future "plottage" increments from assembly, or "negative plottage" from subdividing.
Professors Haig and Simons have given their names to the standard definition of income which includes unrealized appreciation of durable assets like land and corporate shares as current income. Stock brokers and real estate brokers habitually do the same thing for the trade. They may appear to question it when lobbying for tax breaks, at which time some say it is "double taxation" to tax both current cash flow and appreciation. When selling stock or real estate, however, unrealized appreciation is unequivocally touted as current income, and correctly so.
Some even deny that appreciation should be taxable income at all. Yet, no one denies that depreciation should be a deduction from current taxable income. This asymmetry and glaring contradiction generally passes unremarked. It could only survive if never challenged in the profession, which apparently it is not. "Land," with its tendency to appreciate, is not in the abridged lexicon.
Land income also includes service flows other than cash. Because of its versatility, and fundamental character, land often yields service flows in kind, that never pass through the market place. For example, land used for homes and owner-recreation yields no cash flow at all, but has high value.
It is common for economists to write of the "imputed income of durable consumer capital." especially owner-occupied houses, and occasionally to persuade some political candidate to advocate including their imputed income in the income tax base, or at least to end the deduction of interest and property taxes paid on house values. Those making such proposals, unfortunately, fail to exercise reasonable care in distinguishing houses from land. Much or most of the non-cash service flow received from consumer capital proper is not income at all, but two other things: a return from operation, maintenance, and upkeep; and a return of capital. Depreciation and expenses offset more than half the service flow from most owner-occupied houses, especially middle-aged buildings on the steep slope of the depreciation curve. The service flow from land, on the other hand, is pure income.
The measure of this imputed land income is not subjective nor fuzzy. It is interest on the market price of the land, a measure of its opportunity cost (cf. B-14 and A-2). Alternatively, it is the periodic ground rent on comparable lands.37 This could easily be included in the base of the present income tax, converting it in one stroke into a national land tax.
37. In 1992 the US Congress passed an energy policy law including a provision that the worker who receives a parking space from his or her employer must pay income taxes on its imputed value in excess of $155/month. The imputed value is simply what nearby or comparable parking lots charge. Employers are supposed to figure the value and include it on W-2 forms, beginning with 1994 taxes. (David E. Rosenbaum, 1994, "IRS eludes parking tax law." New York Times News Service. Riverside, California, The Press-Enterprise, 24 Feb., p. A-12.) Read the whole articleMason Gaffney: Property Tax: Biases and Reforms
Priority #1. Safeguarding the property tax
Priority #2: Enforce Good Laws
Priority #3. De-Balkanize Tax Enclaves
Priority #4. What Tax to Fight First?
Priority #5: Make Landowners Pay Their Taxes
Use the Building-Residual Method of Allocating Value
It is equally important to use the "Building-Residual Method" of allocating value between land and buildings. This means you value the land first, as though it were vacant, based on highest and best use. You subtract this land value from the total value of land-&-building as currently improved: the residual, if any, is building value.
Valuing one lot or parcel this way, you have information needed for valuing neighboring and other comparable parcels. Using a map with value contours, you can value a whole city this way with surprising ease and speed.
Using this method, I valued Milwaukee land in 1963 and 1967. The building-residual method nearly tripled the land values reported by the City Assessor, who was using the assessor's usual inconsistent mix of various other methods. How's that again? Did I say tripled? Yes, I really said "tripled." By his methods, buildings on the eve of demolition were carrying values higher than their sites; by the building-residual method these old buildings had no value at all, which of course is why they were being torn down. Besides depreciation and technological obsolescence, many buildings suffered severe "locational obsolescence," owing to shifting demand patterns. The land was re-usable, and had as much or more value without the extant buildings.
Using the building-residual method requires no change in present laws. It is within the latitude of assessing officials, who, in turn, respond to public opinion. The conscientious citizens' move is to educate and bring pressure, just as the old single-tax campaigners like Jackson Ralston did. In the process of "losing" they won over half of what they sought, just by taking a stand and making the effort.
Federal Income Taxes
One of assessors' greatest problems today is the strong pressures from owners who want to allocate as much value as possible to buildings that they may depreciate for federal income tax purposes. Here is where we must study how the parts form the big picture. Here is where federal and local tax policies intersect. Some Georgists have neglected or misunderstood the income-tax treatment of land income. Let us see how this works.
Congress and the IRS let one depreciate buildings, but not land, for income tax. This important distinction harks back to when the income tax was new, and Georgist Congressmen like Warren Worth Bailey, from Johnstown, PA and Henry George Jr., from Brooklyn were instrumental in shaping it.
When a building is new, the depreciable value is limited to the cost of construction. The non-depreciable land is the bare land value before construction. So far, so good. Over time, however, building owners have converted this into a tax shelter scheme. Owner A, the builder, writes off the building in a few years, much less than its economic life, and sells it to B. "A" pays a tax on the excess of sales price over "basis." The basis is reduced by all depreciation taken, so any excess depreciation is "recaptured" upon sale. It is defined by Congress as a "capital gain," and given the corresponding package of tax preferences:
Thus far, any tax preference goes to A, the builder, and may be seen as a wellconsidered building incentive. Watch, however, what happens next. "A" sells to B and B depreciates the building all over again, from his purchase price. To do so, B must allocate the new "basis" - i.e., his purchase price - between depreciable building and non-depreciable land.
How shall B allocate the new basis? Enter the local tax assessor. Here is where local assessment intersects with Federal income tax policy. The IRS does not try to assess land and buildings. Instead, IRS instructions tell taxpayers they may use locally assessed values to allocate basis between depreciable buildings and non-depreciable land. The IRS accepts this allocation as conclusive. As a result, local owners of income property press their assessors to allocate as much value as possible to buildings, and as little as possible to land. This does not affect their local taxes, but lowers their federal taxes. It lets them depreciate land.
Local revenues are not immediately affected. Local assessors have little reason not to accommodate their constituents, local landowners, to help them depreciate land for federal and state income tax purposes. They have little reason to use the correct "building-residual'' method of allocating value, and a compelling reason to use the wrong method that understates land value. Thus they convert non-depreciable land value into depreciable building value. It is the modern version of "competitive underassessment." In the process, they also convert the local property tax from a land tax into a building tax.
After a while B sells to C, who in turn sells to D, so each building is depreciated many times. So is a large part of the land under it, time after time, although it should not be depreciated at all. This is carried so far that real estate pays no federal or state income taxes at all.
The solution to this lies with the U.S. Congress. The need is to limit depreciation to one cycle only. It is a most urgent problem for both federal and local treasuries. We all have Congressmen. Write to them and raise their consciousness. They are brokers who respond to public opinion. It is we who are derelict. Read the whole article
Charles T. Root — Not a Single Tax! (1925)
Jeff Smith and Kris Nelson: Giving Life to the Property Tax Shift (PTS)
John Muir is right. "Tug on any
thing and find it connected to everything else in the universe." Tug on
the property tax and find it connected to urban slums, farmland loss,
political favoritism, and unearned equity with disrupted neighborhood
tenure. Echoing Thoreau, the more familiar reforms have failed to
address this many-headed hydra at its root. To think that the root
could be chopped by a mere shift in the property tax base -- from
buildings to land -- must seem like the epitome of unfounded faith. Yet
the evidence shows that state and local tax activists do have a
powerful, if subtle, tool at their disposal. The "stick" spurring
efficient use of land is a higher tax rate upon land, up to even the
site's full annual value. The "carrot" rewarding efficient use of land
is a lower or zero tax rate upon improvements. ...
The Methodology of Real Estate Appraisal: Land-Residual or Building-Residual, and their Social Implications http://www.michael-hudson.com/articles/realestate/0010NYURealEstate.html
How to lie with real estate statistics: The Illusion that Makes Land Values Look Negative; How Land-Value Gains are Mis-attributed to Capital http://www.michael-hudson.com/articles/realestate/01LieRealEstateStatistics.html
Where Did All the Land Go? - The Fed’s New Balance Sheet Calculations: A Critique of Land Value Statistics http://www.michael-hudson.com/articles/realestate/01FedsBalanceSheet.html
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Wealth and Want
... because democracy alone hasn't yet led to a society in which all can prosper