[http://groups.yahoo.com/group/LandCafe/]

Editor’s note: This contribution came in to the Land Café of The Commons
today,

and was posted by the authors who are identified at the conclusion of this
piece.
******************************

Can Soaring Land Values Serve as Riga's tax base?

Prof. Michael Hudson and Prof. Jeff Sommers

For the past five years, the city of Riga has been experiencing a real
estate boom that has multiplied prices for many apartments as much as
ten-fold and more. While this is somewhat faster than has occurred in cities
such as London and New York (where prices have only doubled or tripled in
the past five years), the basic principle is similar. Yet, the forces behind
this asset inflation are not widely understood, although the dynamic is
quite simple and well known by many mortgage banks who are fueling the
property-price inflation.

Most cities and states throughout history have financed their public
spending by a property tax. This tax typically has been levied on the land's
economic surplus - its rental value. Ever since the Physiocrats and Adam
Smith, economists have recognized that this land value is provided by
nature, or in other words as said in the real estate business, its location,
location, location! It is geography, not the creation of value by people,
that give this land its value.

Increasingly, banking systems throughout the world have focused on lending
money against hard collateral - and the largest asset category in every
country is still the land, even in today's industrialized world. In America
and Britain, some 70 percent of bank loans take the form of mortgage loans.
This means that as bank credit expands, most of it is channeled into the
real estate market, thus inflating prices.

The hope of making a price gain - or simply for families to buy before
prices rise even further - leads buyers to vie with one another to buy
property. The natural limit is reached when absentee speculators agree to
pledge all the property's rental income to the bank as interest. In the U.S.
real estate market the motto of investors is that "rent is for paying
interest." Their hope is to resell the property later at a capital gain. The
banker gets the current rental value and the property owner gets a chance to
come out with a capital gain. In Latvia the situation is far more extreme,
and thus financially more precarious than in America and Britain. In Riga,
rental income from most apartments provides only a fraction of the interest
payments on any mortgage taken to purchase an apartment. Indeed, many
apartments are not rented at all, but instead held in order to sell dear.
People take credit to purchase apartments, whose real value is in their
location more than the building itself, in the hopes of realizing a quick
return on resale. To be sure, while Riga real estate was undervalued just a
few years back, the current situation resembles the 1998 ruble crash, in
which investors put ever more money into Russian bonds expecting fast
returns only to see the bubble burst when the ever upward increasing amount
of money required to fund the high returns finally ran out.

The important variable in this is the local property tax rate. As home and
apartment prices rise, they feel squeezed by having to pay as much as 40
percent of their income to service their mortgages and pay property taxes.
In Riga the figure on mortgage payments can be even higher. The response to
this in the US and Britain, realizing that they will be in danger of
forfeiting their property if they miss an interest payment to the banks, is
for many homeowners to campaign for lower property taxes. But, banks for
their part know that whatever the tax collector gives up will be available
to be paid out as interest. So they back "populist" political agitation for
lower property taxes, claiming to support the "little man," especially small
homeowners who find themselves strapped by the heavy mortgages they have
taken on. But when the dust settles after taxes are cut, more rental value
is left free and clear to be pledged to the banks as mortgage interest on
yet higher mortgage loans for yet higher property prices.

This process already is squeezing many in Riga. Fortunately, there is a
simple way to bring property prices back in line with affordability. All
that Riga and other cities need to do is to tax about half of the rental
value of land - not the buildings, because that would discourage
construction, but only the value of land itself. A small 3 percent tax on
assessed property values would mobilize the value created by Latvian
prosperity to be used by the government to build the kind of economic
infrastructure that the country needs to develop and become more prosperous.
Moreover, Latvia has among the highest income and wealth inequalities in
Europe. This measure would help address this issue and facilitate the
country's further development while creating political stability and
fairness in the process.

The question is where should the money go? All to the banks and property
speculators, or directed to educational, economic, health, and transport
infrastructure needs? The answer is surely the latter, but there is even
reason to believe the current situation in Riga is bad for the banks'
long-term interests. If property values continue escalating at present rates
the resulting popped real estate bubble could leave them holding an
unsustainably large set of bad loans. This would be bad for them and the
country. While there are differences to be sure, one must remember that it
was precisely this kind of real estate bubble that contributed to the
Japanese and Thailand recessions in the 1990s from which these countries
have still not recovered. Indeed, one of the few countries to escape the
East Asian crisis was Singapore, which intervened with monetary policy to
slow down the real estate market before it burst.

Yet, one way to continue Latvia's impressive economic growth without
resorting to tighter credit policies is to levy a land tax. Indeed, failure
to tax land value will oblige Latvia to do one of two things, each of which
is even more burdensome for labor and industry. Without a proper real estate
tax, either the country will have to keep its onerous income tax on labor
and industry, or retain its regressive sales tax; or it would have to borrow
the money, requiring higher future taxes to pay interest charges on this
debt.

One way or another, someone in Latvia needs to pay for the modernization of
its transport, power, communications and other civic improvements. The least
burdensome way to do this is via a land tax, because the land exists whether
or not it is taxed, but labor and capital investment will be discouraged by
taxation. The more tax that can be raised from real estate, the less
interest the banks will be able to charge, and thus slow down the increase
in land prices. This will keep housing prices more in line with what
Latvians can afford. And to top matters off, the absence of an income and
sales tax on labor and industry will help the nation compete more in global
markets, creating a broader distributed prosperity for the country and not
just narrowly for property speculators. Indeed, another advantage of a
higher land tax, including land on which apartments rest, is that it would
curb some of the speculative excess. Currently, there is no penalty for
buying apartments and keeping them off the market until prices climb. A tax
would impose a real cost on holding apartments through taxes needing to be
paid on the property whether in use or not, thus encouraging their sale and
use. This should moderate price growth.

In today's world where countries are vying with each other to create a
prosperous, competitive labor force and investment climate, keeping housing
prices in line by minimizing the economy's debt overhead is emerging as the
decisive factor in comparative international costs. Most countries have
similar technological modes of production today. Where they differ is in
their property and financial overhead. The largest factor explaining
differences in comparative international costs is how capital and real
estate is "costed," that is, whether its rental value serves as the national
tax base (in place of taxing labor and industry) or is paid to the banks as
rising mortgage charges on increasingly expensive homes and office
buildings.

Latvia has a chance to gain a lead over neighboring Baltic and Scandinavian
states by keeping its housing and building prices low via a land tax. Many
Latvians no doubt feel that they are getting rich as property values rise.
But a real estate bubble is not truly a sign of rising prosperity; it means
merely that the economy is being distorted and becoming debt-ridden that
will serve as a future drag on growth.

* * *



*Prof. Hudson is Distinguished Professor of Economics at the University of
Missouri (Kansas City), Harvard Fellow, and monthly commentator on PRI's
radio program "Marketplace.

*Professor Jeff Sommers is the Visiting Fulbright Professor at the Stockholm
School of Economics in Riga.



--
Posted by ericbritton to The
<http://the-commons.blogspot.com/2005/07/16705-can-soaring-land-values-serve
-as.html> Commons: A day at the office at 7/16/2005 08:24:00 AM

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