China is failing to heed Michael Hudson’s salutary 2012 warning below, to capture a far greater part of the economic rent of her land as she continues her incredible modernisation. Although she operates six property-based taxes and much of her land has been alienated for a term of years, China has nevertheless allowed most of her land rent to be expropriated and privatized, creating multi-millionaires and more billionaires than exist within the USA. Meanwhile, the rural poor struggle to subsist.
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Avoiding the West’s Debt and Rent Overhead:
A Land Tax is needed to hold down Housing Prices
Michael Hudson
How can China avoid the “Western financial disease” – a real estate bubble followed by defaults and foreclosures? The U.S. and European economies originally sought to avoid this fate by taxing the location’s site value. A rent tax was the focus of Progressive Era reforms.
Enacting a rent tax remains China’s main challenge to accompany its privatization of real estate and natural resources. If land rent were fully taxed, it would not be paid to banks as interest for rising mortgage loans – and governments would not have to tax income and sales. Holding down housing debt will reduce labor’s cost of living, but not its living standards.
While Western economies shrink in response to debt deflation and fiscal austerity, China continues its unprecedented 30-year growth. Many Western forecasters warn that it must suffer a Western-style financial crash, as if this is a universal path. But China has been industrializing and raising living standards by public credit and infrastructure investment similar to the mixed private/public balance that raised America, Germany and France to world power as their Industrial Revolutions gained momentum in the late 19th century. Its keys are active public investment in infrastructure, subsidized education and urbanization, rising wage levels and progressive taxation.
Neoliberal economists have a blind spot that blocks them from understanding why their own nations succeeded so well – and hence, how the U.S. and European economies have veered away from the policies that powered their industrial takeoff. The classical ideal was to free production and consumption from economic overhead remaining from the medieval and colonialist conquest of the land, and the subsequent privatization of banking and money creation.
By the time Mao’s Revolution gave way to the last generation’s reforms, China had largely freed itself from the post-feudal rentier classes that survived in non-Communist countries. Western critics warn that rising wages will erode its competitive position. But higher living standards are a precondition for raising labor productivity, and help China to support its domestic market while Western economies are contracting.
There is no inherent need for China to suffer a Western-style decline. In fact, the West’s own financial and real estate bubble was not inevitable. It is the result of financial and tax policies that reversed the progressive tax system that powered American and European prosperity before 1980, so the financial sector and bankers have obtained the lion’s share of gains over the past thirty years. China’s greatest challenge is to remain free of these financial and real estate dynamics that have plunged the Western and post-Soviet economies into debt and created a rentier over-class receiving income simply for ownership privileges, not for playing a productive economic role.
Real estate’s policy challenge: To tax land rent, or let it be paid as interest to the bankers
Classical and Progressive Era policies aimed to prevent this fate by taxing land rent, natural resource rent and monopoly rent. This led the rentier interests to mount a counter-revolution that has gained power over the past century, especially since 1980. Neoliberalism has blocked what the West’s its classical ideologists of industrial capitalism and free markets promoted: taxation of unearned income, that is, “economic rent” and the “unearned increment” of rising land prices that should be the natural tax base.
If land’s site value – the rent-of-location – is not taxed, it will be “free” to be pledged to banks to obtain mortgages. Larger loans support higher housing prices, because a property is worth whatever a bank will lend purchasers to buy it. In the United States the motto of real estate investors (and homeowners) is that “Rent is for paying interest.” When buyers bid against one another for housing or other property, the winner is whoever is first to pledge the entire flow of rental revenue to the bank in exchange for a mortgage to buy the property. Much of the financial and real estate bubble stems from rising land prices financed by going deeper into debt. “Democratizing home ownership” on credit has enabled banks to end up with the land rent that hitherto went to a landlord class.
Now that rentier property ownership is developing in many ways like the West, the task of the coming generation is to make sure that China remains free of the real estate and financial bubble that has left entire Western economies in debt peonage and negative equity. China thus is facing a universal problem of how to steer its economic surplus into new capital investment (including public infrastructure) and rising living standards to create a thriving domestic market. Its challenge will be to avoid repeating this fatal path that the United States and Europe have taken since the 1980s. The aim is to prevent the economic surplus from being absorbed by rising land rents, prices for monopoly goods and services (roads, commercial privileges, communications and the like), and banking charges for interest and fees.
Over the next twenty years China will have to cope with the same problems of urbanization, rising housing and land prices that Western economies experience. The most important way to view these universal problems is to ask who is to receive the economic surplus: the government as taxes, individual property owners as rent, or banks as interest? This is the basic trade-off. Whatever “free” rent-of-location the tax collector relinquishes is available (“free”) to be pledged to banks as interest.
Defining a fair price that reflected costs of production (value) rather than economic rent (the “free lunch” with no counterpart in necessary production costs) was the focal point and central policy issue of classical political economy. Already in the 13th century the Churchmen discussed a Just Price for bankers to charge for their services. The focus turned to land rent from the Physiocrats in pre-Revolutionary France to Adam Smith, David Ricardo and John Stuart Mill in Britain. The Industrial Revolution led European countries to encourage capital formation to build up their productive capacity. The constraints on this investment were twofold: first, the economic overhead of land rent of their landed aristocracies, and second, the rise in public debt and its parallel growth in taxes to carry the interest charges. (Private-sector debt was still deemed fairly marginal, and was largely productive as it had focused on commercial trade financing since medieval times.) Land rent and interest absorbed the economic surplus without their recipients – the rentier classes of landlords and “coupon clipping” bondholders – performing a productive economic function.
Malthus defended the economic role played by landlords by pointing out that they spent their rental income on hiring butlers and other servants, and buying carriages and fine clothes. Their demand for the products of labor thus played an important role in the circulation of income between producers and consumers. But most classical economists defined “productive” labor as that employed to produce goods and services at a profit. Spending rental income on consumption – especially luxury consumption – dissipated the surplus rather than investing it to raise output.
What industrial economies needed was tangible capital investment, not consumption by the idle rich. Throughout Europe and North America the great political fight of the 19th century was to tax away the landed aristocracy’s groundrent and the political privileges that protected it (most notably the aristocracy’s control of the upper house of parliaments, such as the House of (Land) Lords in Britain). The aim was to free industrial capitalism from the vestiges of feudalism, above all from the hereditary landlords whose ancestors had conquered the land and carved it up for themselves. The landlords argued, in effect, what Margaret Thatcher later would summarize in her phrase, “There Is No Alternative” (TINA) to the way things were.
But there was an alternative, of course. John Stuart Mill in Britain, Henry George in the United States and his followers such as Leo Tolstoy in Russia, and Sun Yat Sen in China campaigned to base the tax system on land and natural resources rather than industry and labor. Their argument was that leaving landlords to extract the rising flow of land rent “free” of taxes would oblige labor to pay rising prices to rent or buy housing. This would prevent landlord-ridden economies from competing in world markets (and even in their own market). This was still an epoch when industrial trade surpluses were needed to obtain monetary gold, which backed the money supply needed to circulate the flow of goods and services being produced. So a land tax was a key policy in achieving industrial surpluses. (Also needed was public infrastructure investment and an industrialization of commercial banking, discussed in greater detail below.)
Taxes on land rent are paid out of prices set in the market, independently from the cost of production of land and subsoil mineral resources. Supplied freely by nature, the supply cost is zero – but the supply is limited by nature. This is why antiquity treated mines as public property, to be leased out, and the land as the major source of fiscal revenue. By contrast, income taxes on wages and sales taxes on consumer goods raise the price of living, and hence the cost of labor to its employers. By the same token, taxes on profits raise the supply price of industrial capital.
Yet today, property taxes have become the least popular of all throughout the West. As China discusses what an appropriate property tax level should be, it is important to understand the political and above all the financial interests that have led to the rejection of classical rent and tax theory. Why has the tax burden been shifted onto consumers, by income taxation and value-added “excise” taxes, instead of achieving the classical ideal of taxing land and “free lunch” rent?
The reason for this reversal in tax philosophy is that home ownership has been democratized – on credit. About two thirds of families in the United States and Britain now own their own homes, and over 80 percent in the Scandinavian countries. These homeowners have come to think of themselves as landlords in miniature. And indeed, many families have risen into the middle class largely by the rising market price of their homes. During the bubble years (since about 1990), “capital” gains (mainly land-price gains) far outstripped the rise of national income in the United States and many European countries. Many families saw the price of their homes rise by an amount larger than what they could earn in an entire year!
Land’s site value is enhanced by two factors that do not reflect costs undertaken by the landlord. First is public spending on infrastructure: roads and public transportation (busses, subways and railroads), water and sewer piping, power and phone lines, and the proximity of good schools, shopping centers and libraries or cultural centers. Second is the general level of prosperity. The neighborhood where one lives and works often defines one’s status, so most people – and companies – spend their rising income on housing or office space in the most prestigious location they can afford.
The result is a kind of circular flow between public spending and rising rental value for neighborhoods. This is especially clear in the case of spending on schooling. Families pay more to live near a public school. In effect, the land’s rental charge is a payment for public services. This is why land taxes are so high in the most prestigious neighborhoods of American cities.
But in many cases the rising rental value has become the proverbial “free lunch” – income or asset valuation without any cost of production on behalf of the fortunate recipient. In London, for instance, the Jubilee Line tube extension raised property prices as easier access to public transportation made homes and offices more valuable all along the route, especially nearest to the new stations. Economic writer Fred Harrison reports that “£3.4bn was invested in the extension of the Jubilee Line to service Canary Wharf” to enable London’s financial and insurance sector to expand. It raised the price of land by upwards of £10 billion. “Land owners contributed nothing towards the increased value that accrued to their assets.” Taxpayers bore the cost, leaving landlords with a windfall gain – one that largely eluded the tax collector.[1]
No public funding would have been needed, and no increase in fares for passengers to defray the capital expense of building the subway route. Its cost could have been financed by bonds issued against taxes to capture the ensuing “windfall gains” for the public – a land tax on the higher rental value created for sites along the route. In fact, the owners of Canary Wharf property offered to build and pay for the Jubilee line extension themselves, at a cost of around £800m, recognizing how transportation would increase the rental value of their location. But local Members of Parliament urged the Thatcher government to include extra stations along the line, so the City of London turned down this offer of private funding. The cost was borne by taxpayers (and Tube users, in the form of higher fares). This left landlords to receive the uplift in property values – what 19th-century economists called the “unearned increment.”
This is why the classical economists urged land taxation, both to recapture the expense of public infrastructure investment and, subsequently, to reduce housing prices but not leaving this “free” rental value available to be capitalized into bank loans and paid to creditors as interest. By freeing government from having to tax labor or capital, and by paying for capital investment out of a rent tax (to provide transportation at subsidized prices) a tax on land and natural resource rent provides a double cost saving for the economy, minimizing its cost structure.
How banks now end up with the land rent – and how their loans raise property prices
Most families today seek to own their own home (and as they earn more, to buy a high-status gas guzzling car to drive to and from work). But given the high price of land – capitalizing its market rent into a bank loan – the only way that families can afford to obtain a home is to borrow the money from a bank. And in today’s world, this means taking on a lifetime of debt and paying the bank some 40 percent of one’s earnings for many households in the United States.
This is a major reason for America’s recent de-industrialization and that of Britain. Even if they give their workers all their food, clothing and other consumer goods for free (currently absorbing only about 30 percent of their wages), their labor still cannot compete, given the enormous cost of carrying the bank mortgages needed to obtain housing, and other debts and taxes.
The financial, insurance and real estate (FIRE) sector has a vested interest in confusing the public when it comes to value, price and rent theory. Bankers in particular promote the short-term view that raising real estate taxes adds to the cost of housing rather than lowering it. Of course, the immediate effect of a property tax increase is that it has to be paid. But by absorbing the land’s “free” rent, this tax lowers the after-tax rental income available to pay bankers as mortgage debt service. So banks will lend less to new buyers, lowering their ability to bid up property prices.
Banks want to lend as much as they can, to absorb all the rental income if they can do so. So they naturally back “anti-government” tax ideology – and as a byproduct, oppose government spending and all other public services. The trick is to convince homeowners and other voters that lower taxes will make the cost of housing less expensive – instead of shifting the beneficiaries of land rent from governments to the bankers. And to cap matters, bankers seek to distract voters from realizing that if the government does not tax land rent and other unearned income, it must burden labor and capital – consumers and employers. In other words, voters themselves!
The bankers’ junk economics has worked well enough that democratizing home ownership – on credit – has enabled the banks to join the real estate lobbyists to persuade voters in North America and Europe to un-tax land. But this has created an “inner contradiction” in industrial capitalism. Its evolution into finance capitalism run by bankers has entered a seemingly terminal “final stage.” The Bubble Economy has burst and given way to negative equity and Debt Deflation. Debts are kept in place, reducing much of the population and nearly entire economies (in Iceland and Greece) to Debt Peonage as the economy grinds to a halt. The result is a financialized Anti-Industrial Revolution – just the opposite of classical economics as the expression of industrial capitalism in its epoch of upswing.
This tax shift off unearned income to create a post-Communist rentier class obviously is not a Western practice that China should adopt. But the former Soviet Union gave neoliberals a free hand in turning land and natural resources over to insiders and slashing taxes on them – while imposing stiff “flat tax” on labor’s income. The result was so right-wing that it never could have been passed in the United States. And it was as economically polarizing as it was politically polarizing, causing the post-1990 drastic deindustrialization and capital flight, mainly to the United States. But to cap matters, North America and Europe also have steadily un-taxed their land, subsoil rights and finance to create a debt-leveraged bubble economy.
It is said that one learns from mistakes. Fortunately, it is not necessary to learn from one’s own mistakes, if one is attentive to how others have gone astray. The financial and real estate bubble has priced the United States, Britain and other leading “financialized” economies out of world export markets. Their experience should serve as a warning for what China should avoid.
China’s transition from leasing rights to a land-rent tax
The transition from public ownership during China’s early Revolutionary Period to privatization of land rights is unique in comparison to Western development. The first priority was to enable construction to occur at the most efficient and hence lowest practical cost. The government sold property registration rights and security of ownership for specified period (usually thirty years) as if they were what would be considered lease rights in the West. These transfers into private ownership aimed to give the new owners an opportunity to raise the funds to erect the buildings that have transformed China’s urban skylines and become the largest capital investment over the past thirty years.
What was left out of this privatization has been a site-value tax on the land’s tremendous rise in rental value. In the United States, professional assessors recalculate real estate market prices every few years. But no such “best practice” has been introduced either in China or in the post-Soviet economies. Where the FIRE sectors gains power, they seek to delay re-assessments.
There is a certain irony here. The West has at least retained the classical practice of realizing that site rental values are a free lunch and therefore it is fair as well as fiscally efficient to capture the rising rental value for the public sector. Communist countries aimed to free their economies from unearned rentier income. Yet having done so during their revolutionary period, they have all but forgotten how to restore this basic fiscal practice. In Russia and the Baltics, this has resulted in such extreme polarization between rich and poor that their economies are shrinking and their populations emigrating.
This is the most important uncompleted task of China’s post-Revolutionary phase. If it refrains from collecting this rising rental value (as the Soviet Union refrained from doing when it broke up), the first result will be to create a New Class of rentiers growing rich on “windfall gains,” that is, on rising land prices resulting from public spending and the general economy. The second result will be that future transfers of this property will occur on credit – on terms that pay the banks the rental value, simply for the privilege of creating new credit electronically on their computer keyboards. Pledging the rising free-rent value land and natural resources as collateral for bank loans turns rent into interest. New buyers pay the un-taxed “free location rent” to the banker as interest. This builds rent and financial charges into the price of housing and office space.
These two dangers threaten to divide China’s economy first into real-estate owners and renters, and then into creditors and debtors. The effect will be the same kind of inequity between haves and have-nots that has occurred in the West – and is dragging down its economies today.
At issue is the proportion of wage and salary income that must be paid for housing. In Germany about 20 percent of the typical employee’s budget is spent on housing. In the United States this ratio is twice as high, often over 40 percent. The reason is that U.S. banks have loosened their credit terms to inflate housing prices. This is the Asset-Price Inflation phase of the Bubble Economy. Similar increases in the price of housing have occurred in Ireland, Britain and other European countries that have followed neoliberal pro-bank policies. Bankers have ended up with the economic rent that invading armies originally pried out of Europe’s public domain a thousand years ago.
This obviously is not the aim of Chinese reconstruction. In trying to create a fair and equitable society that also is productive and competitive, its aims are quite similar to those of classical political economy. As noted above, that was largely a reform program to free industrial capitalism from the surviving vestiges of feudalism. The labor theory of value aimed at isolating the economic rent as a margin that either was to be taxed away (for land and natural resources that were privatized) or kept in the public domain (for infrastructure and other natural monopolies). But since World War II an anti-classical, pro-rentier logic has sought to defend real estate and financial incomes as “earned” rather than unearned. And especially since 1980 a financial and real estate bubble has shunted Western industrial capitalism onto an increasingly parasitic mode of finance capitalism that adds to prices instead of bringing them in line with cost-value.
The great challenge for China today is how to avoid going down this path. It is not an inherent path of “capitalism,” and certainly not of free markets, It is capitalism run off the tracks, in a way that has been endorsed and even applauded by the vested real estate and banking interests gaining at the industrial economy’s expense.
China’s path to higher wages and rising living standards
It is of course good for China to raise its living standards. This is in fact a precondition for increasing labor productivity. They actually make labor more competitive, because high-wage labor undersells low-wage “pauper” labor. This means that rising wages need not impair China’s growth or international export power. Rising wages are a precondition for labor to become better educated, better fed, better housed, better clothed and in better health. The “American System” of political economy was based on recognition that high-wage labor tended to undersell “pauper labor,” thanks to the correlation between rising wages and productivity.[2]
However, higher housing costs do not constitute an increase in real wages or living standards. They are overhead, not output. This is what makes rent theory different from value theory, and the FIRE sector different from the “real” economy of tangible production and consumption. Value is a real cost of production, and hence adds to prices; rent is paid out of prices, with no corresponding cost of production. Failure to draw this distinction has been built into today’s post-classical national income and product accounts (NIPA). This accounting is a bankers’-eye view of matters – deeming it productive to simply exploit others in a zero-sum (or even negative sum) activity. This is not the view of real wealth and economic growth that 19th-century classical economists had in mind when they set out to reform the economy by freeing markets from the claims of earned income and special interests. And it certainly is not what China’s managers have in mind.
Privatized or public infrastructure?
An allied problem was elaborated in the United States in its late 19th-century debate over whether to keep and develop basic infrastructure in the public domain or to privatize it as a legal monopoly while regulating its rate of return. Providing its services at subsidized prices, or even freely as in the case of roads, and sponsoring technological development (or in Germany’s case, industrial imitation of hitherto British secrets of steel-making and other heavy industry) was a key element in lowering the nation’s cost of living and doing business – and hence, enhancing its export competitiveness. Simon Patten, America’s first professor of economics at its first major business school – the Wharton School at the University of Pennsylvania – defined public infrastructure as a “fourth” factor of production, alongside land, labor and capital. In most countries this public investment in roads, communications, harbors, water and sewer systems, electric power and gas was larger than industrial investment in plant and equipment. However, its return was not measured in the profits it squeezed out to make money for its owners (under public ownership, the government). The gains from public investment took the form of lowering the price of living and doing business.[3]
The neoliberal policy that guides today’s World Bank and Wall Street is the opposite of the policy that the leading industrial nations pursued during their own takeoff to world leadership. This is what is so remarkable about the inversion of economic thought and ideology that has occurred over the past half century. The outstanding issue for China today is which philosophy of development to follow: the classical economic policy of minimizing economic rent to hold down prices, or the anti-classical (“neoliberal”) policy of turning real estate and public infrastructure into private hands to “democratize” it by borrowing purchase money from the banks and paying out the economic surplus to them?
The West has reversed the classical growth and fairness model
To classical economists a free market was one in which prices were brought in line with technologically and socially necessary costs of production. This meant freeing prices from land rent, monopoly rent, natural resource rent and returns to financial privilege. Economic rent is “empty” pricing in excess of cost-value. Rentiers (landlords, coupon clippers, bankers and other monopolists) extract income without playing a direct role in production. More than a century of classical economists was followed by a generation of Progressive Era reforms to promote industrial progress without unfair “unearned income.” Their program was to tax economic rent (land rent, mineral rent, monopoly rent and financial privilege) and provide public banking and credit.
The United States and Europe provided their industrial exporters with a competitive advantage by providing basic infrastructure at subsidized prices or even freely: roads and other transportation, education, public health, pensions, communications, electrification and power generation, water and sewer developments. For the past thirty years the West has reversed these progressive developments by privatizing ownership on credit, financed by banks. Much as homebuyers and speculators purchase real estate on credit, so do the buyers of infrastructure. Like homeowners, they pledge the property’s “economic rent” (in this case, access fees) to the banks to pay interest on the credit to buy these privileges.
Western observers have celebrated this shift to making money by debt-leveraged gain seeking as inaugurating a post-industrial epoch of prosperity without work. In economic terms this means an economy of predatory income extraction and asset-price gains without cost value. And in adopting this economic philosophy the West has redefined the idea of “free markets.”
This is not a new phenomenon. Most public fortunes throughout history have been carved out of the public sector. From Bronze Age Sumer in the third millennium BC down to the great American railroad and land-grant fortunes of the 19th century and post-1980 European Thatcher-style World Bank-sponsored privatizations, this has occurred largely by insider dealing. And to cap matters, banks and high finance are the mother of monopoly, creating a symbiotic relationship with vested landed interest, mining, oil and gas, monopolies and trusts from North America to Europe.
The explanation for how Western economies have de-industrialized thus is not to be found in rising wage and benefit levels. These have are falling, not rising. What is rising most rapidly are debt service and new emerging monopolies, paying income to creditors and monopolists rather than for goods and services. The domestic market shrinks.
When economies shrink, prices decline for real estate and other assets. But the debts remain in place, pushing finance capitalism into its Negative Equity stage: debts in excess of the ability to pay. In such circumstances, “saving” for families and companies, and even for governments, takes the form of paying down debts. The more this occurs, the deeper the debt deflation and economic shrinkage. This explains the austerity that now plagues the West.
The upshot is that Western bankers and financial sectors have achieved the dominant position that landlords held at the time of the Industrial Revolution. Like landed aristocracies, the new financial barons are making themselves into a hereditary class – irreversibly. The problem has grown more serious since 1980. The finance, insurance and real estate (FIRE) sector has used its gains to buy control of government and its regulatory agencies, the courts, mass media and the educational system. The aim is to distract voters from perceiving the predatory financial dynamic, by replacing realistic economic analysis with a public relations lobbying effort (junk economics).
Many of the West’s problems today stem from untaxing the rental value of land, mineral rights and public infrastructure, leaving it “free” to be pledged to bankers. Contrary to Progressive Era policies, the rising market prices for urban and rural agricultural sites is being paid to bankers to create new hereditary vested interests, rather than used as the tax base to keep prices affordable for housing and office construction. This means that today’s tax policies are re-creating a feudal-style over-class of landlords and bankers with financial fiefdoms – the opposite of how Western industrial economies grew rich and productive prior to the 1980s.
It is ironic that rivals of China accuse now talk about a Clash of Civilizations. Western observers are reluctant to acknowledge the degree to which China is aiming to achieve the kind of “free markets” that classical economists defined as making economies more efficient and competitive: taxing and regulating the rentier interests whose rent and interest have burdened the Western economies since medieval times. It is the West itself that has veered away from the direction in which its civilization was traveling under the direction of classical political economy and Progressive Era social reforms. Placed in this context, the West’s financialized Bubble Economy represents a lapse back into a pre-industrial rentier economy. It is entering a lost decade or perhaps an entire lost generation.
The problem is one of economic structure. Entire national economies have taken a wrong turn. Western economies will not recover automatically by “internal stabilizers.” Their present decline is not a transitory part of a financial cycle; it is deeply structural. Debt has no stabilizers except foreclosure, transferring property from debtors to creditors – or default or debt writedowns. Debt defaults, foreclosures, collapsing property prices and bank bailouts are the result of neoliberal bank deregulation and tax philosophy that has made today’s financial sector what landlords were in the 19th century: rentiers monopolizing the economic surplus, without playing a direct role in production.
Neoliberals call their coup d’état a “free market” and attack criticism as if it were an attack on Western civilization itself. Yet the attempt to free European and American economies from the legacy of medieval military conquests and banking was what came to define Western civilization in its Progressive Era leading up to World War I.
What are the best ideas for China to adopt from the West?
China admired the United States and other Western economies for their high consumption standards. But these haven’t risen for the past 30 years. So which “West” should China admire? Should it be the classical Western strategy of heavy government subsidy and protectionism that underlay their rise to industrial power? Or is it the recent counter-revolution sponsored by rentiers to de-industrialize the West under the slogan of a post-industrial economy in which people are supposed to get rich by borrowing credit to speculate on rising real estate and stock market prices, and on corporate takeovers by business-school graduates using “financial engineering” to replace industrial engineering by using corporate profits to buy back their stock and thereby raise the value of their stock options?
A hundred years ago the classical policy for economic growth was to reduce – and ultimately tax away – the land rent and natural resource rent hitherto paid to landlords and mine owners. Ricardo developed his theory of land rent to oppose Britain’s protectionist agricultural tariffs (the Corn Laws) that kept food prices high – and therefore the living wage that industrialists had to pay. If Britain were to out-compete other nations to become workshop of the world, it would have to feed its labor at a low price. In 1847, Britain repealed its Corn Laws and embraced Free Trade Imperialism. It offered foreign countries duty-free access to its food and raw materials markets if they would agree to not impose tariffs on British industrial exports. Speaking on behalf of the banking interests, Ricardo thus threw his support behind industry rather than landowners.
Socialists went so far as to urge outright nationalization of the land, natural resources and natural monopolies (transportation, communications, universities, etc.). Marxists extended this policy to industrial capital, which was in the process of being organized into giant trusts. Followers of Henry George argued that collecting the land’s rent would provide the advantages of nationalization while leaving ownership in the hands of individuals, retaining the benefits of market feedback. Britain’s House of Commons passed a land tax in 1909/10, but the House of Lords rejected it, creating a Parliamentary crisis. In Russia, the Kerensky interim government planned to introduce a tax, but was overtaken by the Bolshevik Revolution in October 1917, which nationalized all property.
After the Soviet Union was dissolved in 1991, its member countries did not pick up the logic of land-tax reformers earlier in the century. By this time the West itself was reversing the pre-1980 trend toward progressive taxation, and was untaxing real estate. Tax policy was becoming more regressive, shifting the burden onto consumers and even onto industrial employers. This benefited the financial, insurance and real estate sectors, but raised the price of doing business.
Throughout these developments, real estate has remained the largest asset category in all economies, and the land’s site value is the main component. This gives China the same choice that faces the United States, Europe and the post-Soviet economies: Should land’s rental value be the basis of the tax system, or that of the financial system?
To restore their industrial growth, financialized economies need to replace their pro-financial, anti-government model with the classical doctrine of freeing economies from real estate and financial rentiers. A land tax holds down property prices. The more land rent is taxed away, the lower housing costs will be – along with the economy’s debt overhead, and hence its overall price levels. But if land is not taxed – or if the real estate tax rate is lowered – this will leave it to be loaded down with debt. The lower the land tax, the higher the mortgage debt, as rental income is turned into a flow of interest by new buyers as land prices rise – on credit.
This is the path that the United States and other Western countries have taken, while the post-Soviet states since 1991 have been the most extreme in taking neoliberal advice to favor real estate and finance over labor and industry. Their self-destructive real estate bubble has loaded down their labor force with high debt service and housing costs, while their giveaway of public infrastructure to insiders (with no price regulation) has led to high basic living costs. Their disastrous collapse, capital flight, emigration of skilled labor, shrinking GDP and corruption should serve as an object lesson for what China should avoid.
Favoring the FIRE sectors over labor and industry has starved governments of taxes at the state, local and federal level and pushing their budgets into chronic deficit. Meanwhile, mortgage lending has overburdened economies, loading them down with interest charges for housing, commercial buildings, and for the purchase on credit of many services that China and socialist countries provide freely or at subsidized public prices.
Student debts to finance education are a notorious example of financialized infrastructure. They amount to over $1 trillion in the United States – more than credit-card debt. Defaults are rising sharply as graduates have difficulty finding employment in the debt-strapped U.S. economy. Yet banks are guaranteed such high interest rates by the government that many scandals have broken out about banks paying kickbacks to university officials who promote some banks over others to obtain this lucrative, high-interest/low-risk market.
One effect is to leave many students unable to afford rents on apartments away from their parents’ home. So new household formation slows, deterring a recovery of real estate markets as marriage and birth rates fall. Meanwhile, economic polarization increases between creditors at the top of the economic pyramid and debtors among the bottom 99 percent of the population.
Summary: China’s best choices to keep its economy fair and well-balanced
This is not the trend that Western economists expected a hundred years ago. What began in the 13th century by the Scholastics (the Churchmen) as a theory of Just Price to analyze how much banks could fairly charge for their services of credit and international transfer of funds was applied to land rent. The concept of economic rent was generalized to include the excess of market price over and above the socially necessary costs of production. By the 18th and 19th centuries a reform movement emerged seeking to replace aristocracies and oligarchies with democratization of land ownership. The aim was to liberate Europe from the hereditary landlord class that had conquered it in the 9th through 11th centuries, from that continent’s colonial conquest of the New World, Africa and Asia, and in America from the real estate and railroad barons who obtained land grants by insider dealings. The idea of economic democracy from the French Physiocrats through Adam Smith, John Stuart Mill and subsequent Progressive Era reformers was to base the tax system on real estate and natural resources or publicly created privileges, as distinct from property that was the product of its holder’s own labor and enterprise.
But as matters turned out, housing and property ownership was democratized on credit. Economic rent (value created by public infrastructure spending and the land’s site value) was pledged to the banks as society’s newly dominant rentier class, replacing the landlords that hitherto had been the main elite. Since the 1980s the West has reversed classical tax policies and public regulation, un-taxing real estate and finance, shifting the tax burden onto labor and its employers.
Tax favoritism for the finance, insurance and real estate (FIRE) sector has replaced economic democracy with financial oligarchy. Capitalizing economic rent into bank loans and paying it as interest increases the price of production. It does so in a way that leaves debt deflation in its wake. And to cap matters, governments must tax labor and industry if they do not tax land rent and financial returns. That raises the break-even cost of living and doing business.
Instead of Western politicians asking how to reverse their decline, they insist that “There is No Alternative” (TINA) but to pay the debts that were run up or suffering more foreclosures, unemployment and even emigration – even at the cost of imposing chronic depression. The resulting austerity makes budget deficits even worse, polarizing economies between creditors and debtors.
The thrust of classical economics was to make economies competitive by bringing prices in line with technologically necessary costs of production (defined as including normal profits). This was done by keeping natural monopolies in the public domain or, in the case of land and mineral resources, by taxing their economic rent. This is the task that remains for China’s industrial and urban revolution: to keep housing costs down, and to prevent speculators and insiders from carving fortunes out of the public domain.
The West’s financial polarization was not inevitable. China need not suffer this fate. It can democratize real estate, natural resources and industrial capital without turning their rental value over to the banks. And by following the appropriate tax and financial policies, China can keep credit focused on financing capital formation and growth, rather than taking the form of economic overhead such as is now dragging down Western economies into debt deflation and austerity.
China’s policy makers need to bear in mind that neoliberal (that is, pro-financial) Western advice has steered its own economies down the road to negative equity and debt peonage. Instead of promoting industrial capitalism, financial interests within the U.S. and European economies have sponsored a post-industrial counter-revolution against the classical idea of free markets, that is, markets free of unearned land rent, monopoly rent and financial interest and fees.
In sum, while China has followed Western advice to privatize and decentralize much of its economy, the West has gone much further in relinquishing planning power from the government to the banking sector. And although local Chinese councils have been allowed to obtain revenue by selling land to developers, generating fees in property rights, this has left the land’s rising site value free of taxes. The nominal land-lease payments are more in the character of registration rights than actual land taxes.
To continue growing, China needs to keep its balanced socialized economy free of the West’s Bubble Economy and its descent into negative equity and debt peonage. This freedom is best achieved by adopting the classical policy of taxing land rent and other natural resource rent, and to regulate the price of basic infrastructure services and natural monopolies to keep their prices in line with necessary costs of production. This means avoiding “financialized” costs of production. Now that banking provides credit “freely” on computer keyboards, this function – and the interest it generates – should be kept in the public domain. Banks should be public institutions – and foreign banks should not be permitted except for bank branches performing a limited array of services, as long has been the case in the United States.
[1] Fred Harrison, Ricardo’s Law (London: Shepheard-Walwyn, 2006): pp. 83f. Harrison’s Wheels of Fortune points out that Hong Kong funded its excellent mass transit system from land rents collected from commercial properties around its stations. His analysis is available at http://www.iea.org.uk/publications/research/wheels-of-fortune.
[2] I summarize the American School and its Economy of High Wages doctrine in America’s Protectionist Takeoff: 1815-1914, and in Trade, Development and Foreign Debt (2010, Chinese translation Remnin University Press, 2011.)
[3] I summarize Patten’s views in “Simon Patten on Public Infrastructure and Economic Rent Capture,” American Journal of Economics and Sociology 70 (October 2011):873-903, and in America’s Protectionist Takeoff: 1815-1914 (2010, Chinese translation 2011).