A module from:
The Hidden Taxable Capacity of Land: Enough and to Spare
By Mason Gaffney
6-e. Current unearned increments as current rents
Professors Robert Murray Haig and Henry Simons gave their names to “Haig-Simons” income, a definition of taxable income that includes unrealized unearned increments, taxable IN THE YEAR THAT THEY ACCRUE, not waiting for sale. Many, probably most economists until the Gingrich Era endorsed Haig-Simons, at least in principle. Harold Groves and William Vickrey are two of the better-known. In 1966, Canada’s Royal Carter Commission recommended Haig-Simons at a high political level[i]. Dr. Joseph Pechman of the Brookings Institution devoted much of his career to promoting his “Comprehensive Income Tax Base” based on Haig-Simons. (Pechman, like Heller, studied under Professor Harold Groves at Wisconsin.)
In 1973 economist Harry Kahn, inventorying untaxed kinds of income, estimated that UNrealized capital gains were 10 times the value of realized gains; and that the excess of unrealized over realized gains was about 20 times the value of imputed housing rents[ii]. His figures may have been casual, but clearly this is a huge item. Since then, “capital” gains as a fraction of income have swelled.
Few economists or others seem aware that “capital” gains are mostly land gains, misnamed. Most capital depreciates, by nature; it is land that appreciates. That is why the little island that Pieter Minuit bought from the Canarsee Indian tribe in 1626 for $24, and the lands Thomas Jefferson bought from Napoleon for $15 millions in 1803, are now worth trillions, while their buildings have gone, and come and gone and come again, many times over. Mislabeling land gains as “capital” gains seems calculated to keep people in the dark, and it has succeeded because so many people live in thrall to “The Tyranny of Words”.
Land gains are a form of taxable land rent, as we will demonstrate. But as gains grow so do the wealth and political power of the political and allied academic movements to untax them. So much greater, then, is the need for objective economists to establish the taxability of capital gains, to show how to tax unrealized gains as they accrue, without disincentive effects or administrative nightmares. We need to scope out the new revenue potential that now largely escapes taxation.
A property tax based on the market value of appreciating or “ripening” land IS a tax on the accrual of value, levied annually as the value accrues. How is that? In a reasonably perfect market for futures, the annual increment is the current price times the interest rate, say 5%. The property tax is the current price times the tax rate, say 2%. Therefore the tax is a fixed portion of the current annual increment. Economists of high repute and mathematical ability have been astonishingly dense about this. William Vickrey, for example, who campaigned to have capital gains taxed as they accrue (rather than on sale), declared there is no simple way, as he worked out schemes to do it in complicated ways that only a theorist of his brilliance could love[iii], and not even a theorist of his stature could sell, not even to fellow economists[iv].
Owners of appreciating land have long noted this, from their own point of view, which is to avoid taxes, whatever havoc they wreak on the English language. They have agitated to have the property tax base converted from market value to a multiple of just the current cash flow. They call this “capitalized income”, and have sold their terminology to the world. It is well below the Discounted Cash Flow (DCF) of all future rents (see Equations 1-3, below). DCF is common coin in private appraisal work, but not in public assessments for taxation.
Some George champions point out there would be no unearned increments if the property tax on land values were raised high enough (and buyers and sellers expected it to remain high). Thus they dismiss thoughts of how we get from here to Nirvana, and how we make do en route. “Some for the Glories of This World, and some sigh for the Prophet’s Paradise to come”. As to “This World”, perfectionists also dismiss the income-tax version of the capital gains tax because it is an imperfect tax (which it is). It is levied only at time of sale, making it (as Wicksell wrote) a tax on commerce, a barrier to allocating land ideally. But its virtue depends on “compared to what?” It certainly beats the income tax sans a capital gains tax.
As to the last, the capital gains tax, being part of the income tax, actually serves a useful political role en route to the Prophet’s Paradise. It makes the income tax less attractive to recipients of land gains, discouraging them from pushing legislators to replace the property tax with the income tax.
That is politics. The central economic truth here, however, is little appreciated, and therefore wants underscoring. It is that the property tax based on land value, remarkably, taxes both the current rent, and the current unearned increment as it accrues. Both at once; both at the same rate! Thus, En route to the Prophet’s Paradise, it offers something “Alike to those who for Today prepare, and those that after some Tomorrow stare”.
Some say that is double taxation, or making something out of nothing. That overlooks that we are traveling through infinite time. Use up a century or two; infinite time remains. The future nears, but not the end. There is always tomorrow, and tomorrow, and tomorrow, undiminished by all our yesterdays. We die, our works crumble, the very paint on the “immortal” Mona Lisa cracks, photo-chemical smog eats at the Parthenon, the facing sloughs off even the Great Pyramid of Gizeh, but space on Earth survives, as fresh for new mornings as it was on the First.
Normally, future rents will be higher. That raises the discounted cash flow (DCF) of the present by taking from an infinite reservoir of time, gaining something while losing nothing. Like infinity, it is counter-intuitive and hard to conceive. Our minds are geared to finite lives in finite time. Yet markets have adapted to the infinite life of land since time immemorial. Even those who preach that the end-time is near buy and sell land at the market.
Here is the mathematics[v]. Let V be market value; let it also be assessed value. Let t= the property-tax rate, a= the current annual rent, and g= an annual percentage rise of “a”. Then:
V = a/(i+t-g) (1)
You may derive (1) using high school algebra for the sum of an infinite geometric progression.
Rearranging terms, we single out the annual gain of V, which is Vg, and denote that as V’:
V(i+t) = a + V’ (2)
Solving again for V:
V = [a+V’]/(i+t) (3)
Again, V’ is the current annual rise of V, the “unrealized capital gain” that is part of Haig-Simons income – current income. The denominator, (i+t), is the usual “cap rate” used by land appraisers and assessors. It is the way of capitalizing “a” into the corresponding V when V is land value subject to an annual tax. If that looks novel, it is only through neglect. It is common coin in land appraisal. Its reciprocal, 1/(i+t), is the Englishman’s “Years’ purchase” of land. It has been with us a long time: it is the Frenchman’s le denier of which Turgot made so much in his Réflexions, 1766. It resembles the stockbrokers’ P/e ratio, but with a property tax added.
(3) tells us that a free market treats V’, the annual rise of V, as current income, as Professors Haig and Simons said it is. It capitalizes it into V by the same cap rate that it applies to “a”.
Finally, a tax rate, t, applied to the base V, taxes “a” and V’ at the same rate.
Tax = tV = t/(t+i) x (a + V’) (4)
(4) shows that the tax rate is being applied equally to a and to V’, year after year. The true tax base, then, is higher than a; it is (a+V’). The fisc’s share of this net income is t/(i+t)[vi].
If future rent is to be heavily taxed, there will be less current value and less appreciation. One might think that increments would thus be destroyed, but economic value does not disappear without a trace. It is conserved, like matter and energy. The value is rather transferred to the public. The right to levy future taxes has a present value, too. The public can and does take current cash out of unrealized increments to this present value in the same way private owners do, by banking them.
Thus, debt expansion soundly grounded on a rising tax base is current income that the owner, private or public, may take as cash. It is part of what the public may spend currently from the tax base, without reducing the net worth of the public equity, or damaging public credit. Lest this seem reckless, recall that public debts have been rising for a long time, in step with rising taxes of other kinds, which are mortgaged to public debt. The rationale, found in most economics textbooks, has been in terms of rising gross national product, which shrinks debt relative to tax base.
One must be cautious: this is sailing close to the wind, and spendthrift rulers can get in trouble, as they have throughout history. The federal government turned to folly after Arthur Laffer sold the “dynamic budgeting” notion that lower tax rates cum wider loopholes would mean higher revenues, and Robert Barro sold his version of “Ricardian Equivalence”, that higher public debts stimulate offsetting higher private saving, and neo-cons sold the notion that war is quick and easy and profitable. But the idea forwarded here is to raise tax rates on a rising base, and close loopholes. It is not to finance aggressive wars, although one must recognize it would make it easier to do so.
Capital gains as a revenue source can be quite unstable. California’s 2003 fiscal bind illustrated the danger. The real estate bust of 2007 will soon do the same. This is not a drawback of the present proposal, however, for this differs from the current income tax on capital gains in several ways.
- The proposal here is to tax gains as they accrue, not upon sale. Sales are much more unstable than prices: they soar on a rising market, and drop like lead on a falling market, redoubling the drop of the tax base.
- The proposal here is limited to land gains. Current income taxes, on the other hand, include gains from other sources like building up a new business. During the dot.com boom that broke in 2003, it was this last element that was most unstable.
- During a land boom and bust, land taxes, if assessments were kept current, would be a strong stabilizing factor – a factor that has been missing. Many assessors refuse to follow a rising market, with wheezes like “These crazy new buyers are paying more than the land is really worth”. Never mind that the buyers are risking their own money in the game, while the Assessor observes from the bleachers. Implicitly, “I, the Official in Charge, know better than the market”.
However, the Assessor by law is supposed to follow a bull market, not outguess it. When the “exuberance” appears in his wisdom to be “irrational”, his job is still to go along, not judge. When private fee-appraisers go along they confirm and reinforce a boom, but when the tax Assessor goes along he douses a boom with cold water: higher taxes[vii]. It was the lack of such an automatic remedy that let the farmland boom of the 1970s soar so dangerously high above reality and the urban bubble of the late 1980s, and now of 2001-2007.
[i] Carter Report (Ottawa: Royal Commission on Taxation, 1966)
[ii] C. Harry Kahn, 1973. “The Place Of Consumption And Net-Worth Taxation In The Federal Tax Structure”, in Musgrave, Richard (ed.), Broad-based Taxes. A Supplementary Paper of the C.E.D. Baltimore: Johns Hopkins University Press, p.147
[iii] Vickrey, William, 1948? Agenda for Tax Reform, ……….; and 199x, “—“, Proceedings of AEA, pp. ….
[iv] One enthusiast, to his credit, is Alan Auerbach
[v] For more general models see William Vickrey’s Appendix II to Gaffney, Mason, 1971, “Tax-induced Slow Turnover of Capital V”, AJES 30(1): 105-11, pp.107-08; and Gaffney, Mason, 2006, “Keeping Land in Capital Theory: Ricardo, Faustmann, Wicksell, and George”, a paper delivered at the annual meeting of the History of Economics Society (H.E.S.), Grinnell College, June 25, 2006; Revised, July 2006, for publication in the AJES, 2008; and Gaffney, Mason, 2006, “A Simple Measure of Tax Bias”, AJES, Summer.
[vi] In case it should become an issue, note that taxing gV does not lower either g or a. These are both before-tax values, independent of the tax rate on land.
[vii] Gaffney, Mason, 1985, “Why Research Farm Land Ownership and Values”. In T.A. Majchrowitz and R.R. Almy (eds.), Property Tax Assessment (Chicago: U.S.D.A., International Assocation of Assessing Officers, and The Farm Foundation, 1985), pp. 91-109.