16 July 2005

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

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.
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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.

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*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.

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