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SCI LIBRARY

A Rule called George:

Fixing the Property Tax System

David Robinson



[7 June, 2002. David Robinson is a Professor of Economics at Laurentian University]


This month we begin what we hope will become an ongoing INORD series. We will be presenting simple, but not widely understood ideas from economics and other social sciences that Municipal Councilors can use to make our communities better.


Introduction


When the Ontario Fair Tax Commission handed its report to Floyd Laughren in December of 1993, it reported that "Local government finance issues were raised more often in the commission's public consultation process than all other tax issues combined." They went on to say,"The system of local government finance is so complex and arcane that it is incomprehensible to most Ontario resident " It is fair to say that after almost a decade of reforms the situation is only a little better.

Part of the problem is that the existing system was designed the wrong way from the ground up. Most reforms are aimed at making the wrong approach less harmful.

The secret of a good property tax system has been discovered, however. Meet George. If you understand George, you'll understand some of the key problems in municipal government. You also understand how to solve those problems.

George is actually the Henry George Rule, a little known but extremely powerful principle for running local governments. The principle is that local governments should try to maximize the property values. The value of a piece of property depends on the community and what the community does. The local government is doing its job when it makes the largest possible contribution to property values.

There is one tricky point that you have to get clear to really understand George. The relevant value of land is price plus the value of all the future taxes. Why should taxes be counted as part of the value of the land? The cost of using a piece of land has two parts - the price of the land PLUS the tax bill. When there is a free market for land, sales only happen when the benefits are at least equal to the price plus the taxes.

This insight leads to a simple rule for city council.

Never OK a project unless it increases the value of the land and future taxes by more than it costs.

That is all there is to the Henry George Rule.

Of course there is an equally important POSITIVE version of the rule:

OK a project if it increases the value of the land and future taxes by more than it costs.

The positive version is harder to implement. City Council doesn't have enough money for all the projects that this rule says it should do. The nature of property taxes gets in the way. Increases in the market price of the land go to the owners. Property owners collect the benefits that city council pays for.

When Toronto builds a subway, the landowners get rich, but the rest of the city pays the bills.

The result is that City Councils invest less than they should in their cities because they don't get paid for the benefits the projects would produce. Local governments are usually inefficient because they can't collect fair value for what they produce.

Now you know the Henry George rule. The rest this article provides examples and more explanations. It also provides a little bit of history and some information about Henry George the man.

The Henry George Rule is one of the principles of a well-run city.

The Henry George Rule is one of the basic principles for a well-run city. Economists have proven that if a city follows the rule it will maximize the wealth of the community.

The Henry George Rule is not a very radical proposition. Local governments serve the local population. It is true that not everyone owns property, but it is fairly easy to show that the property values actually reflect the interests of tenants too.

The Henry George Rule has two major problems.

  1. Almost no one knows about the rule
  2. Existing tax laws are set up a different way

    • Property taxes are charged on buildings as well as land.
    • Property taxes are set to cover services like water or garbage collection that are not part of the property value
    • Property taxes are used to pay for services that are not related to property value.

>Who was Henry George and why are they keeping him in the closet?

Henry George died on Oct 27, 1897, in the middle of his second campaign to become Mayor of New York City. He had lost by a narrow margin in 1896 and probably would have won in 1897.

George was also the author of Progress and Poverty the most popular Economics book ever written.

Born Sept 2, 1839 in Philadelphia, George left home at 16. He worked as a sailor, joined the California gold rush, became a typesetter, journalist, editor, and eventually one of the founders of the San Francisco Post.

George was generally seen as a socialist, and his approach was seen as an alternative to Marxian socialism. George's radical reputation is one of the reasons that his ideas have been ignored.

The core of George's prescription was the single tax. He wanted to eliminate all other taxes and finance all public activities through a tax on land. Remember that this is before there was an income tax (It was Karl Marx who was calling for an income tax, by the way). Henry George's ideas were one of the streams that led to the creation of the British Labour Party and the CCF in Canada.


The distribution of costs and benefits.


Say City Council builds a new park, which raises the quality of life. Tenants are willing to pay more to live in the area. The landlord raises the rent. In theory the tenants might be no better off in the end. All the extra value accrues to the landlord.

Or say you build a sewer in the South end of Sudbury. Because the developers say that no one will buy their land if they have to pay the whole cost of servicing the land, City Council pays for some of the sewer with money collected form downtown residents.

The project is the right size, so it maximizes total wealth. Unfortunately, the downtown residents are made poorer and the developers are made richer in the process. Part of the motive for the project is to transfer wealth from one part of the community to another.

The key point is that there is a simple rule.

Local governments control the supply of local public goods. No one else can do this job well. Local public goods influence the value of the surrounding land. In fact, the benefits from local public goods appear as increases in the total property value.

LOCAL GOVERMENTS SHOULD SUPPLY LOCAL PUBLIC GOODS TO MAXIMIZE THE PROPERTY VALUES. In other words. LOCAL GOVERNMENTS SHOULD ACT AS IF THEY OWNED THE LAND AND MAXIMIZE THE VALUE OF THEIR PROPERTY.


The economics of the back fence


This example shows how the technical terms are used.

Imagine that your real estate agent tells you that you could get a higher price if you rebuilt your fence. In other words, the benefit of the fence appears in the value of the property. This is the principle behind the Henry George Rule.

Rent and capitalized value


When someone buys the house they will get some benefit from the fence. The benefit will be spread out over years. The potential buyer is willing to pay the capitalized value or "present value" of that long stream of benefits in addition to the value they get from the rest of the property.


Costs vs Benefits


How would you decide whether you should build the fence? You ask yourself "will it cost less than the increase in the value of the property."

The basic principle is expressed this way: invest in the fence up to the point where the "marginal benefit is equal to the marginal cost". This is the essential rule of cost benefit analysis.


Local Public Goods


What if your neighbour's property value also goes up? When there are spillover effects we say the fence is a local public good. Local governments provide many local public goods, including roads and parks.


Financing Local Public Goods


"Publicness" causes problems. You can't get the whole capitalized value of your fence back when you sell your house because some of the benefits are going to your neighbour. Even though the fence is worth building, you might decide not to build it.Why? Because you only get half the benefits and half the benefits may not be enough to make you want to go ahead.


The need for a public sector


Sometimes it makes sense to have a local government to pay for public goods.

Example: The Toronto subway


This is one of the tragedies of Ontario municipal finance, the Toronto Subway system.

Here is the question: how far out should the subway line be built? Answer: only so far as there is enough ridership to pay for it. Right? Wrong!

The right answer begins with the fact that the subway will increase the property values around every new station. If the total increase in property value is enough to pay for the line and the station then the station should be built.

This is an application of the Henry George Rule. If you don't follow this rule your municipality is not being run efficiently. You have to follow the Henry George Rule to have economic efficiency.

There are a few interesting qualifications to this rule. You should include the fares. Fares should be set to maximize overall rents. But the basic rule would lead to a much larger subway system than Toronto has right now. In other words, Toronto is being run inefficiently.

What stands in the way of an economically efficient subway system?

Why can't you go to your councils and say, "Here is a very simple rule. You should follow it"?

The answer is simple but depressing. If you run an economically efficient municipality the way the rules are set up right now,  you will go bankrupt.

There is no way that the City of Toronto can use the wealth it creates by building the subway to pay for the cost of the subway. The benefits are there, but they go to the owners of the land as capital gains. They go to land speculators in many cases.


Example: Selling Central Park


New York City has a famous park. Central Park is known around the world for a variety of activities that go on there.

New York City is having financial problems.

There is a proposal that Central Park be sold to developers for one billion dollars.

No reasonable user fee will ever collect that much money. Would you advise New York City Council to sell the park?

Because you know the Henry George Rule, you will naturally ask " if we sell the park what effect will it have on the property values for the whole city. After all, it will cut tourism, reduce the attractiveness of the city to people who use the park, and even to those who think they might use the park.

If selling the park reduced property values in the city by 1% and if the total value of the property in New York City were two trillion dollars - not an unreasonable estimate - by the way - selling the park would do more harm than good.

So what advice would you give?  The right answer (if my numbers happened to be correct),  "buy some of the neighbouring land and expand the park!!!" And keep doing it until the increase in total value of the land left outside the park reaches a peak.


Who wrote the Henry George Rule?


Henry George didn't invent the Henry George Rule. John Stuart Mill had already suggested capturing all the capital gains on land. Mill's proposal was actually implemented for crown lands in Britain in 1909 and was applied to all plots of land in the British Town and Country Planning Act of 1947.

George didn't even prove the rule is correct. The first proof was developed in 1974 by Flatters, Henderson and Mieszkowski. It is sometimes called the Henry George Theorem and sometimes called the "Golden Rule." It is actually a general principle derived from standard economic theory.


Taking a Position


Municipalities have to be able to say, "we produced that increase in land value, so we are entitled to levy a charge against the property for the value we created. But how do you know what the effect of a particular project is? Economists have developed some fairly sophisticated techniques for assessing the impact of local public goods. Econometric methods are finally up to the challenge. Even 15 years ago the technical problems were insurmountable. They are not any more.

There are two gaps.

First Gap: There has to be a complete and continuously updated property value database for the province. I say for the province for three reasons.1) Logically we have to have data for a large group of communities. 2) The responsibility for providing the administrative machinery is constitutionally at the provincial level. 3) the obvious way to develop such a database is to build it around an automated provincial land registry and there are major economic gains form moving in this direction.

Second Gap: Who will pay for the system? The answer is that the municipalities would be happy to pay for such a system. What we are really talking about is a major improvement in the billing and collection machinery for local governments. Any business makes the billing and collection part of the price of doing business. Right now the system is so bad that local governments can't collect for what they produce.


What do Economists Think about the Henry George Rule?


George's Progress and Poverty was an all time best seller. But how much influence has George's theory had? The Henry George Rule has won new support from economist in the last quarter century.

The Encyclopaedia Britannica, "few economists of reputation supported" his specific remedy - the single tax. "Nevertheless... his systematic economic analysis provided a stimulus to orderly reform."

W.E. Kuhn, an economist at the Federal Reserve Bank of Chicago, wrote, " What little recognition was given this self-taught economist by the profession, uneasy when stirred out of its complacency, was grudging, and certainly not a fair measure of his analytical competence." (The Evolution of Economic Thought, p155).

Mark Blaug, possibly the most influential historian of economic thinking, called Progress and Poverty a "wonderful example of old-style classical economics" , but he also said " it was thirty years out of date the day it was published."

Flatters, Henderson and Mieszkowski produced the first proof that George was right in 1974.

Pines and Weiss (1976) showed that Henry George was right for a slightly different case. The marginal increase of the land rent in an open and small region correctly reflects the marginal benefit of a public project.

Arnott and Stiglitz also found that Henry George was right. For an optimally run community, the aggregate land rent equals the total expenditure on public goods. The result applies exactly only when the community has the optimal population.

Kanemoto (1980) showed that if a profit seeking company owned all the land in town, developed only the land that was profitable, and set the rental prices to maximize its profits, it would follow the Henry George Rule.

Even more interesting, in Kanemoto's company town, the company would also maximize the welfare of the people living in the town. A mining company, for example, building a townsite on its own land would maximize the total product of the city minus the cost of maintaining the utility level required to attract a workforce. The community that it built would tend to have the same distribution of housing as a planned city or a city that grew up on its own. The result is also the same as if all the land in the city is owned by absentee landlords.

Summary: Economists now know that George was correct. The debate is about whether it is practical to implement the correct approach.