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Capital Gains — or Land Gains?

Our current way of taxing has some odd puzzles in it.  For example, we are taxed on our wages, but every 24 months, a couple can sell a highly appreciated home they've lived in for the past 24 or more months, and exclude from taxation the first $500,000 in so-called "capital" gains!  Those gains are only "capital" gains in a two-factor system of economics: the reality is that they are gains on land values.  Houses and other buildings, as every homeowner knows, depreciate.  We spend our "leisure" time — or our money — in an attempt to slow that depreciation: replacing roofs, heating systems, wiring, appliances.  Houses, being manmade, are, like man, made from dust and in the process of returning to dust.

When wages are insufficient to support one's lifestyle, those who own houses in prime locations turn to their home equity, and borrow against it.  Those without home equity, or in places where home equity rises slowly, do not have this cushion available to them.  Yet it isn't anything that the lucky homeowner has done which produces this cushion for some.  In fact, it is the presence of people waiting to buy, many of whom are paying rent to a landlord, who make his land increasingly valuable.  (And those same people may be paying sales taxes and income and wage taxes to pay for the very services that make the local land more valuable!)

Is there an alternative?  Absolutely.  Lift the taxes from the buildings.  Lift the taxes from wages.  Lift the taxes from sales.  Place the taxes on the land values.  Guess what will happen.  The land's value will not drop by a cent, but its price will go down, making it affordable to those who would put it to good use.  (See capitalization, if you need more detail on that.) The tax one pays will be a function of the value of the site, not the value of the building one places on it.  Big site in a choice location?  Big tax.  Tiny lot in an out-of-the-way location?  Tiny tax.  Pay for what you take, but not for what you make.   Our young people will be able to afford housing in the towns in which they grew up.  No one will be getting rich as a result of being a landholder.  They'll have to turn to honest work — and that work will be available, because the land on which to conduct business will be seeking people to put it to use, instead of telling them to drive further.

Everett Gross: Explaining Rent

Sometimes it's difficult for people to understand the meaning of "rent" as an economic concept. One way I have of explaining it doesn't use the word rent. I just use a little analogy.

I'm from Crete, Nebraska. It's a small town of 5,000 people.

Suppose a man comes to Crete, and he wants to start a business. He needs a building, but first he needs a piece of ground to build this new building on. So he looks up a real estate agent, describes what he wants, and the real estate agent shows him a parcel that's just right for his needs. The man asks the agent, "All right, now how much money do you want for this land?" The agent says, "It's worth $50,000." The man says, "Why is it worth $50,000?" And the real estate agent points out that "The school is good, the roads are good, the police department is good, the rescue crew is good and very fast, and business is good here."

So the man says "Yeah, I believe that $50,0000 is a fair price. I'll take it. How do I pay the $50,000 to the school people, and the road people, and the police department? To whom do I pay the $50,000?" And the real estate agent says, "Oh no. You don't pay it to them. You pay it to the person who owned the land before."

The man says, "But who supports the schools, and the roads, and the police, and the other good things?" And the real estate agent says, "If you build, then you'll pay for them again."

The buyer then asks, "And what will the previous owner do for me for my $50,000?"  The real estate man answers, "Nothing!  Nothing at all!"

Now I don't need to use the word "rent" in that explanation.

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

Turning land-value gains into capital gains

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

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

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

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

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

Michael Hudson and Kris Feder: Real Estate and the Capital Gains Debate
Capital gains taxation has been a divisive issue in Congress at least since the debates surrounding the Tax Reform Act of 1986, which, aiming to eliminate tax loopholes and shelters and preferences, repealed preferentially low tax rates for long-term gains.1 To bring effective capital gains tax rates back down again was President Bush’s “top priority in tax policy.“2 In 1989, Senate Democrats blocked a determined drive to reduce effective tax rates on the part of Bush, Republican Senators Packwood, Dole and others, and a few Democratic allies.3 The administration argued that the tax cuts would stimulate economic growth and induce asset sales, thereby actually increasing federal tax revenues; Congressional Democrats countered that the plan benefited mainly the wealthy, and that tax revenues would in fact decline.4 The Joint Committee on Taxation projected that budget shortfalls beginning in 1991 would sum to about $24 billion by 1994 --  and that most of the direct benefits would go to individuals with over $200,000 in taxable income. House Speaker Thomas S. Foley said that a third of the savings would be enjoyed by those with gross incomes over one million dollars.   Read the whole article
Mason Gaffney:  Full Employment, Growth And Progress On A Small Planet: Relieving Poverty While Healing The Earth
They err even more egregiously, and tendentiously, in making their favorite cause the exemption of “capital gains” from taxation. I put “capital gains” in quotes because most capital gains are land value gains (Gaffney, 1990). “Capital gains” is one of those slippery euphemisms that P.R. people came up with, and the media circulate, to camouflage unearned increments as functional incentives and rewards for creating capital, and investing it in income-creating ways. It’s a way of controlling us by corrupting the language. A tragedy of modern Georgism is how easily its Philadelphia convention, during the first Bush Administration, was stampeded into memorializing Congress to repeal the capital gains tax. A convention of land speculators could have done no worse. Most modern Georgists simply did not understand, or seem to care to understand, how the income tax works. There has been some progress since then; but still, they need to wake up and smell the coffee. Read the whole article

Mason Gaffney: The Partiality of Indexing Capital Gains

We surely agree with Roberts et al. that domestic capital formation is a crying current need; and the means is to foster saving and investing (but properly defined, as below). We also agree there is a strong, bi-partisan case for raising investment flows of the income-creating, work-activating kind. Here, however, we meet the problem of distinguishing new capital from old assets, especially land.

Land is not formed, like capital, by saving and investment; land is not reproducible. For that very reason land tends to appreciate, and therefore has to be a major source of what are misleadingly called "capital" gains. Again for that very reason, there is no supply-side kick in untaxing gains. Most of them are land gains, and should be called that. To use land as a store of value is macro-economically unproductive at best, and on balance counterproductive and destabilizing (considering its effect on financial institutions like the S&Ls).

To handle this matter we need two semantic distinctions which often are lost in the word-fencing of debate. Walter Heller, whose policies still enjoy bi-partisan support, thought and spoke in a Keynesian framework where "investment" means "investing," an affirmative, job-making action. It is a process, not a store of value; an economic flow, not a fund. It is not the asset held: this "investment" is a noun, macro-economically static and sterile. [Land may appreciate, and one may call this "investment," but the appreciation employs no one and creates no new wealth (although it may reflect the externalities of wealth created by others). ]

To signalize these differences I use the present participle "investing," rather than the ambiguous noun "investment."  [Webster's 9th New Collegiate defines investment both ways: it is an action, (the Keynesian usage); it is also an asset being held, a store of value. Such a two-faced word is a natural medium for double-talk, and has been so exploited, to the detriment of general understanding.] ...

As to borrowing on land, that can be worse than barren when the financial system rises and falls on a land bubble, as it has and is.

Heller and his contemporaries also knew that the incentive driving job-making investing is MRORAT, the Marginal Rate of Return after Taxes. [Economists of the 1960s, following Keynes, called it the MEC, or "Marginal Efficiency of Capital," an awkward phrase now little used. Awkward or not, and intended or not, it had great historical consequence by putting the emphasis where it belongs, on marginal rates of return, excluding rents.]

The marginal idea is pivotal. The Average ROR includes rents; the Marginal ROR is the pure return to new investment, Keynes' "inducement to invest," which is activating and functional.

These Heller ideas were invoked again by supply-siders in early Reagan times. However, policy over the course of the 80s lost the substance of that policy, keeping only the guise. Domestic leaders forgot the usage of "investment" in macro-economics.

They gradually slipped into an illusion that buying and holding and bidding up old assets like non-reproduceable lands and stocks would make jobs and produce goods. They forgot to distinguish old from new assets, and marginal from average returns on investment (average returns, recall, include rents). Both critics and supporters of "supply-side" policies now darken counsel by debating current policies in supply-side terms, when the terms no longer describe the policy at issue.

 Along with normal confusion, there is intelligence behind such error. The case for downtaxing gains depends in part on exploiting confusion, in order to pass off rent-raising as an incentive for saving and investing, and so to disguise its non-functionality and eminent taxability. The policy is called "supply side," but isn't.  

The litmus test of the sincerity of capital-formation champions is their treatment of irreproduceable land. Raising rents and land prices, and protecting the gains from taxation, is purely distributive, with no power to foster saving and investing. On the contrary, a higher share for rent and/or land purchase must mean a lower share for the investor in new capital.

Ignoring land and its distinctive attributes has the effect of treating land as though it were true, reproduceable capital, to be formed by saving and investing, to be routinely worn out and replaced in the normal course of life and business. It lets advocates of investing and capital formation abuse the legitimate case for macro incentives, exploiting the case to camouflage unearned, nonfunctional rents and increments to land value.[Brookings' major contribution to our subject is Henry Aaron (ed), 1976, Inflation and the Income Tax, with chapters by 15 eminent economists. Land is treated by none and is not in the index. [It is mentioned in passing only by one, George Lent.]]

Tantamount to ignoring land is minimizing its weight. Thus one may acknowledge it indulgently, while actually dismissing it. In fact, though, land comprises some half the assessed value of taxable real estate in California, and is not dismissable. Half the assessed value means more than half the market value because of assessment discrimination favoring land. A raft of studies of assessment discrimination, like the sales/assessment ratio studies of the U.S. Census, show consistent patterns of discrimination favoring land. In addition to ordinary assessment discrimination there is much legislated underassessment, for land in forest, farm, country club, and other favored uses.

[An interesting recent case involves Charles H. Keating, Jr. of Arizona. He and Kemper Marley posed as farmers to secure "millions of dollars in agricultural tax breaks on land they planned to develop." The breaks result from lower assessed land values for "farmers." [Steve Yozwiak, "Land-tax bill OK reached," The Arizona Republic, 13 April 89.] ...

Most states legislate similar loopholes, widely used by suburban land speculators. More generally, the effect in California of Prop. 13 is to keep much land assessed not much above its 1978 valuation.] If that data were not enough, most of us resident in California have been through one or more years since 1976 when the value of our homes alone rose by more than our annual salaries. ...

Considering the true nature of most "capital" gains, it is not surprising that economists have not come forward with claims of large macro benefits from untaxing gains. The CBO, using a Washington University Model, recently estimated that excluding 30% of gains from the income tax base would raise GNP by only "0.1%" - a number well below the accuracy of any macro model, and effectively zero. James Poterba last year came up with another figure near zero.  ... read the whole article

Mason Gaffney:  Property Tax: Biases and Reforms
Priority #1. Safeguarding the property tax
Priority #2: Enforce Good Laws
  • Reassess Land Frequently
  • Use the Building-Residual Method of Allocating Value
  • Federal Income Taxes
Priority #3. De-Balkanize Tax Enclaves
  • A. Rich and Poor
  • B. Timber and Timberland
  • The Role of Timber and Timberland
  • Two More Areas Deserving Attention
    • Offshore Oil
    • Tax All Natural Resources Uniformly and Comprehensively
Priority #4. What Tax to Fight First?
Priority #5: Make Landowners Pay Their Taxes

The solution is to make the regressive taxes pinch landowners. The income tax, when new, was designed to do exactly that. Georgists like Congressman Henry George, Jr. and Warren Worth Bailey took the lead in shaping it to do so. Over time, though, it has changed into mainly a payroll tax, and as it changed it became increasingly popular with landowners. It served their greed and became the clarion call of their constant clamor for "property tax relief."

In 1942 Congress excluded 50 percent of "capital" gains from taxable income, and broadened the definition of "capital" assets. As top-bracket rates on "ordinary" income rose above 50 percent, Congress capped capital gains rates at 25 percent. Meantime, wage-taxwithholding was sold as a wartime measure - "We must all do our duty." College professors were dutifully indoctrinating their students that the income tax is the perfect tax: fair, progressive, allocationally neutral, all at once.

Then income tax rates went wild, going as high as 92 percent on "ordinary" income (but capped at 25 percent for capital gains). Federal and state income taxes became the mainstay of public finance. Owners of income property soon learned to avoid almost all income taxes by claiming short tax lives by which fictitious inflated depreciation write-offs offset all their cash flow. Once a property has exhausted its depreciation "basis," owner A sells the property to owner B, who depreciates it all over again, and so on through several rounds. The only "recapture" of this excess depreciation is when A sells to B for a capital gain; in effect, the rent of income property shows up as "capital gains." This tax burden is minimized by keeping rates low on capital gains.

Many who think of themselves as "Georgists" have shut their eyes to this important matter. Some simply declare a pox on all forms of income tax. Others even join the hue and cry for exempting capital gains, specifically and preferentially, from income tax. These positions are, I submit, foolish. So long as we have an income tax that treats land income kindlier and gentler than wage and salary and interest income, so long will we have perpetual clamor for "property tax relief" by shifting the burden to incomes, until no burden remains to shift - a condition we are approaching in half the states. Read the whole article

Mason Gaffney:  Sounding the Revenue Potential of Land: Fifteen Lost Elements
Correcting for downward bias in standard data
c. Use of “NIPA” accounts from the U.S. Department of Commerce

 The standard source of data on GNP and its components is the National Income and Product Account (NIPA), kept and published regularly by the U.S. Department of Commerce. When it comes to rent, however, NIPA depends on the IRS figures, which thus are passed along to all students of economics as the “official” accounting. We have just seen how far from reality these data are.

NIPA is worse, in a way, because NIPA explicitly excludes “capital gains” from National Income. That is, first the IRS converts rents into capital gains, and then NIPA banishes capital gains from GNP, National Income, and National Product. “Capital gains” is an artificial term, that includes all gains realized from the sale of what Congress defines at any time as “capital assets.” “Capital assets” include land and improvements, housing, common stock, growing timber, breeding herds (including race and show and riding horses), mineral and hydrocarbon reserves in the ground, and several other favorite holdings of the rich and well-connected. As we saw in “b”, most commercial rents show up as capital gains, so that NIPA does not report them at all. Then along come highly visible economists like Paul Samuelson, Robert Solow, Theodore Schultz, Edwin Mills, Jan Pen, and others to look up this datum, and declare that land rents are no more than 5% of national income, and cannot possibly support modern governments. This is unfortunate, and quite misleading.

  NIPA is better by virtue of its making a gesture at including the imputed value of owner-occupied housing. Whether they do it right is a question on my agenda. Read the whole article

Nic Tideman: Land Taxation and Efficient Land Speculation

Taxes on Realized Gains from the Sale of Land

A tax on realized gains from the sale of land shares with a tax on realized income from land the characteristics of imposing no explicit cost on holding land idle and falling on entrepreneurship as well as land. It has the additional unfortunate feature of being avoidable by continuation of ownership. If there were no improvements in the efficiency of land use that depended on transferring land title, a tax on gains from the sale of land would have no distorting effects and would also raise no revenue. To avoid the tax, people would simply lease land rather than sell it, and no tax would be collected. The general principle involved here is that if a tax is levied on a good for which there is an untaxed perfect substitute, everyone will use the substitute, there will be no welfare losses, and there will be no tax revenue.

Another set of conditions under which a tax on realized gains from the sale of land would have no distorting effects is if landholders were able to obtain a return from land only by selling it, and if there were no entrepreneurship involved in obtaining the best possible sale price. A person indifferent between two options involving different timing of development would be indifferent between the two when what was received was a constant fraction of the returns from the two. However, because it is possible to obtain a return from land not only by selling it but also by using it oneself, and because entrepreneurship is involved in the sale of land, a tax on gains from the sale of land will have the effect of reducing sales and therefore, typically, postponing development. It is also possible that the prospect of paying the tax would induce a landholder to undertake a modest, premature development under on his or her own, when in the absence of the tax the landholder would wait and sell the land to specialists in development. Whether the development is advanced or postponed, however, the effect of the tax is to reduce the efficiency of development.

In the U.S., a further consideration that causes development to be postponed is the possibility of avoiding Federal income taxes on increases in land value by including the land in one's estate. Estate taxes are paid according to the actual value of the land (as they would be paid on the proceeds if the land were sold), but one's heirs pay taxes only on the increase in value after it leaves the estate, so that taxes on the increase in value during one's lifetime can be avoided. ... read the whole article

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

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

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

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


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Wealth and Want
... because democracy alone hasn't yet led to a society in which all can prosper