Designing the Preconditions
of a Market in Land

Fred E. Foldvary

[A paper presented at a Conference on Designing Markets, the Association of Collegiate Schools of Planning, University of Pennsylvania, 28 October 1993]

A market is a spontaneous process encompassing the totality of the voluntary economic acts of agents in some context. Hence, markets themselves cannot be designed, since a market is the very opposite of a centrally controlled plan. However, the concept of a voluntary act implies the existence of rules regarding property and human relationships, which when violated render an act involuntary and therefore not part of a market process. These meta-market rules, along with some institutions, precede a market and can be designed, although they may also evolve without any predetermined design.

Research by George Yarrow (1990, p.4) suggests that economic policies have a much stronger effect than privatization per se, which will not have substantial positive results if policy is unfavorable to enterprise. In the policy mix of privatization, demonopolization, and deregulation, the latter two should be given priority (p.5).

Concerning labor and the products of labor, the basic market rule can be that each worker owns his or her own labor, and can freely contract with others as to the terms and products of one's labor. But since natural resources are not products of labor, rules are required determining such ownership claims.

In the economies of Western Europe and their colonized territories such as North America, such rules evolved over hundred of years. But in Central and Eastern Europe, the swift change from central planning to more market-oriented economies do not leave time for such evolution. Hence, the design of market rules is necessary. If not done, or if done haphazardly, the market may become (and has been to some extent) usurped by political and criminal elements who impose their own rules for their benefit.

Before examining the nature of the design for a land market for countries swiftly emerging into more market-based economies, the ethical basis of such rules needs to be examined. If one accepts the concept that a market consist of voluntary acts, then it is clear that the meaning of "voluntary" involves ethics.

The ethics of the market process

John Locke (1690 [1947], p. 123) put forth as the two premises for universal ethical rules the independence and equality of persons. Each person may act independently acts according to one's will so long as others are not harmed, and such acts have an equal legal standing, there being neither masters nor slaves. As noted above, these foundational principles are applied to labor in the market rule endowing each worker the right to her or his own labor and its product. The equality in labor then consists of equal opportunities rather than equal outcomes, since the product of labor is a function of individual effort, luck, and talent. This ethical rule is consistent with the economic theory that production is most efficient when individuals have maximum incentives, which they have when they are able to keep all of their product. Such would apply also to entrepreneurship, which is also labor.

For natural resources, the equality premise implies that the benefits of goods that are not products of labor be distributed equally to the inhabitants of some community. Such benefits are conceptually distinct from the ownership rights of control and exchange of property. Hence, individuals may control the use of natural resources and the exchange of titles, while the rights to the yield of the resources, the economic rent, may be partly or entirely owned by members of some community. Such a split of rights would also be consistent with efficiency, since the individuals holding the rights of control would have the incentive to put the resources to their most productive use so long as they could keep the yields attributable to their efforts, hence not included in the economic rent. Since ownership consists of a bundle of rights, the bundle of controls may be split among various owners, various governments having legal rights of control as well.

A democratic government, as the agent of the member of a community, may be authorized by the members to collect the economic rent of natural resources for use as collective revenue for governance. Moreover, to the extent that the government itself acts as a firm in the provision of collective goods, the site rents generated by the presence of those goods are the logical source of revenues for such goods, making them self-financing.

Market ethics preclude the taxation of wages and goods, these being owned by the workers and producers; instead, aside from user fees, the government has two sources of rent, that due to the, yield of natural resources and that due to the capitalized benefits of its own services. The design of taxes on income, sales, turnover, value added, etc., is therefore an unwarranted copying of institutions that reduce potential economic prosperity. The highest growth rates have occurred in countries with the lowest taxes on marginal or additional income, such as in Hong Kong (Siegan, 1992, pp. 79-80). Maximum growth is obtained when marginal tax rates are reduced to zero.

Hence, ethics and economics yield the following congruent set of foundational market rules:

1) Each worker owns his labor and keeps its product so long as others are not harmed.

2) Rights to natural resources are split between those of control, which can be assigned to market agents, and rights to their economic rent, which can be assigned to members of a community and collected by their agent, the government.

Definitions of land and natural resources

The term "economic land" or, for short, "land," shall be considered here to be synonymous with natural resources. Land therefore includes: 1) the surface of the earth, including both solids (soil) and liquids (lakes and rivers); 2) the economically useful space and materials beneath the surface; 3) the economically usable space above the surface; 4} the electro-magnetic spectrum. The third type of land, air space, includes the use of space for construction, for pollution dumping, and for aircraft routes. This definition implies that natural resources cannot be created, since land as space can only be changed from one usage to another. As land beneath the surface, natural resources consist of materials prior to the application of labor directly upon them. Given some arbitrary boundary line, land is therefore inelastic in supply, and its value is determined by demand and the perceived fixed supply. Of course, the supply of land for a particular use can be variable.

The yield of land above the costs of extraction or use is therefore a rent, and the collection of this rent does not affect the supply of the affected land. Hence, the use of economic rents for government revenues does not decrease productivity or the amount of final product, the ultimate payer being the land owner.

The assignment of titles to land

For economic efficiency, the assignment of titles to land is arbitrary so long as the concentration of ownership is not very high (e.g. with a Herfindahl concentration index of less than .1) . If one agent has a monopoly ownership of the land in a city, for example, then it could extract monopoly rents in addition to the purely economic rents that a decentralized ownership yields, in effect taxing the assets tied to the land. So long as the economic rent is collected and the market agents are able to control production and keep the yields due to effort, the identity of the title holders is irrelevant. However, from an ethical viewpoint, the identities do matter, of course.

The problem of land titles can be treated abstractly as follows. Let L be the totality of land, divided into lots l{. The population consists of individuals i, who may consist of either natural persons or legal persons, the latter made up of associations of legal persons acting legally as one person. Each lot is associated with a set of rights r. A title consists of a subset (synonymously called a "bundle") of such rights associated with a lot. For simplicity, let it be assumed that the set of rights for each lot is identical, i.e. each lot has the same set of rights as any other.

In order to assign unambiguous rights to lots, the lots 1; must be distinct. Each right r must therefore have a clear boundary line with respect to other lots. For example, the right to cultivate a farm lot requires that the boundary of the lot be known. The set of all known boundary lines, when registered with a central authority, is called a "cadastre." One of the key elements of the design of markets is the creation of a cadastre of all the land within a government's jurisdiction. Typically, the records are maintained by a local government agency, but the central government should be able to access it, if not keep its own records. Ideally, all the records would be on computer data bases, accessible from remote terminals. The registry should include lots owned by various levels of government, so that the title holder i of any lot can be identified.

A cadastre includes a map of a jurisdiction, dividing the territory into blocks, with detailed maps of each block showing the boundaries of the lots, each lot assigned a code identifier and also its horizontal and vertical coordinates. Aerial photographs, soil studies, utility maps, and other information can be included or their locations indicated. For each lot, the following entities would be recorded: 1) the boundary lines and area size; 2) the bundle of rights associated with the lot (e.g. the mineral rights can be separable from the rights of residency or cultivation); 3) the identity of the title holder (this can be a fictitious name so long as there is some way of collecting debts from the owner) ; 4) the assessed value of the lot and of assets tied to the lot; 5) a record of taxes or fees paid by the title holder and due in the current period; 6 liens attached to the lot.

For an efficient market in land, the cadastre or registry should be open to the public, so that, for example, those interested in purchasing a lot may obtain title insurance and know what the current taxes are. Also in the public record there should be copies of the deed for each lot. Some of the elements of a complete cadastre, such as the rights associated with a lot, may be contained in the deed. When a title is held by an association, such as a condominium, the deed will specify which elements of the property are common and which are individual.

In countries transforming their land tenure from collective to individual titles, there are three sets of potential owners: 1) those who held titles prior to their confiscation by governments; 2) those who currently possess lots; 3) the population in general (e.g. via vouchers) . In some cases, titles were not confiscated, and the first two categories are contained in the same persons. Mostly, however, case (2) consists of occupants of residential units and workers in enterprises. Cadastres exist in part as records of previous titles or as records of current residences and enterprises.

In much of formerly socialist territory, enterprises such as farms and factories had possession of land, but the boundaries were not clearly delineated, since the government had title to all lands and did not require distinct boundary lines. With the transfer of lots to individuals, the boundaries are now important. Some countries, such as Latvia, are now engaged in cadastral surveys, including the use of Western help. This process will take many years. A cadastre and other registries need not wait for the completion of surveys, but can be organized to record the rough boundaries and the identities of those holding various rights at present. In principle, the creation of a cadastre involves surveying the land and recording the information, although disputed boundaries will need to be resolved according to some rule.

The operation of land rights

The bundle of rights of a lot include the rights of use. By the market rule described above, the rights of use preclude activities harming others without compensation. It is critical, therefore, to specify clearly what "harm" means. The lack of a clear meaning has led to many disputes involving land use in market economies, despite the many regulations applying to land, such as zoning. In many neighborhoods, a change in the use of land is accompanied by aroused opposition of nearby residents, and each significant new usage requires a permit, involving a hearing, the outcome of which is often left to the arbitrary discretion of the committee considering it. Such a process is often inefficient and inconsistent with a rule of law rather than of personal whims, since personal loss is not the same as moral harm. Market competition implies that-some will gain and some will lose, so competition itself should be fully legal.

To design a market in which arbitrariness is minimized and in which productivity is maximized, "harm" requires a clear legal meaning. Let an "injury" be defined as an act which leaves the recipient less well off than he was before. An "offense" is an injury whose effect depends purely on the personal views and values of the recipient. A "harm" consists of all other injuries, being the set complement of offense (Foldvary, 1980). If the effect is not due to purely internal reactions, then some object must be entering (without permission) the domain of the recipient from outside his domain, the domain being the boundary lines of his bundle of rights. For example, trespass and theft cross the boundaries and consist of unwelcomed enterings, or invasions. A harm, then, involves some invasion into one's domain. If there is no invasion, there is no harm, although there may be some offense.

Competition, therefore, may involve financial losses to others, but is not itself harmful, being physically non-invasive. A new use of land, as such, is not harmful, even though nearby residents may be displeased. Pollution, on the other hand, is an invasion of damaging particles into one's domain, and thus a harm. Uncompensated pollution is therefore not a market act, but a violation of market rules. To induce maximal efficiency, the fundamental market rule governing land use, therefore, is that any act not involving a harm be unrestricted, and that any act that does harm others require compensation for that harm, unless the potential harm is so great that it must be entirely prohibited.

As noted by Ronald Coase (1960), in a small-numbers case, where the costs of negotiating are not large, the cost of a harm can be determined by negotiation, so that the cost is the change in enterprise that induces the least compensation and still leaves the agent with the same utility. In a large-number case, such as with air pollution, the costs are somewhat arbitrary, but can be given a relative ranking, so that some overall charge is made for total pollution. As discussed below, the various pollutants are assigned some percentage, and each polluter then pays a charge proportional to the amount of each type of measured pollutant.

The rights of exchange have often been restricted in the emerging market economies. In Latvia, for example, those obtaining title based on descent from ownership in 1940 have been restricted in selling the land for a number of years. People not holding citizenship have been prohibited from owning, though not leasing, land. From a purely economic perspective, such restrictions are not necessary and impede the most efficient use of land. Fears of the takeover of the benefits of land by foreigners would be eased if the economic rent of all land were collected by government agencies. For market efficiency, the transfer of land should be left unrestricted so that title becomes transferred to those who can use it most productively. In Latvia, for example, some new title holders of farmland have little knowledge of farming, but since the: carrying cost of holding the land is almost nil, the land remains underused.

The unrestricted right of exchange also precludes any controls over the price and rent of land. Prices set below market-clearing rates transfer the economic rent from the title holder to the tenant or buyer and inhibit the most productive use of land. Speculation in land can be prevented by collecting the rent, which implies that future rents will not be capitalized into land value. Each time that a lot is sold, the price should be recorded in the central registry. Information on lot sales, as well as leases and options, can then be used by the authorities in the assessment of the value of the lots.

While markets cannot fully function until laws regarding contracts and bankruptcy are established, with enforcement by the police and through civil law suits, the market process can begin before such laws are enacted in detail if the general principle of contract, property rights, and bankruptcy rules are established, preferably in a constitution. Their enforcement can be left to court judges and juries until more detailed rules are drawn up. Trial by jury is therefore a much-needed element of the enforcement of market rules, with jury selection left to random selection rather than the choices of government officials, with juries being able to judge both the facts and the legitimacy of law, depriving local officials of arbitrary powers.

The productive use of land not only requires the freedom from legal restrictions on its use and exchange, but also protection from costs and restrictions imposed by criminals acting as an underground government. Eastern Europe and Russia are plagued by racketeers who impose "protection" charges and monopolize some of the profitable industries, such as taxi service to airports and hotels. Government agents, including police, are often paid off by the racketeers, or impose their own private taxes, e.g. at border posts. Hence, the design of efficient markets must include a major effort to reform government to weed out corruption and then eradicate organized crime. Such crime thrives on arbitrary powers of restriction, which endows permit powers with "market" prices. (The restriction of border crossings, for example, creates a value for permission to pass, collected by border guards.) A major element of the elimination of crime and corruption is therefore the elimination of arbitrary taxation and restrictions, denying government agents the power to profit from imposed costs.

Designing privatization

One way to resolve the problem of the transfer of property from government to private ownership is by a decentralized, market-driven privatization. The government in this approach is a passive supplier, the transfer of property being driven by the active demands of entrepreneurs and buyers. If the workers of an enterprise state farm wish to buy or lease it from the state, they would have the opportunity to do so by auction. If some outside agent wishes to acquire it, the agent too would be able to do so. Auctions also reduce the problem of bureaucratic favoritism and corruption.

The government would gradually reduce the subsidies to the enterprises and then charge market rents for the sites occupied, providing a gradually increasing incentive for the workers to privatize. As new private firms and farms are founded, wages and profits on these ventures will be greater than those in the government sector. This will provide an incentive for the workers or outsiders to become private or bid for the property.

In decentralized, market-driven privatization, any bid for government property shall be accepted as the opening bid for that property by public auction. The bid is publicized and others are invited to bid, and then the property is auctioned to the highest bidder (with the existing occupant having a right to match the highest bid and remain in tenancy) . Such a public auction avoids the practice of the appropriation of land by the nomenklatura, the old powerful elite. "Luxurious country homes, for example, have been sold to senior officials at bargain prices, presumably land and all" (Redfearn, 1992, p. 161). Laws would inflict penalties for officials who obstruct these transfers or who prevent any agents from bidding, with some of the fines given to the people who successfully identify those officials.

Such spontaneous privatization avoids the some of the turbulence caused by economic shocks caused by swift, centrally-directed transitions. It also enables a flexible, case-by-case devolution of enterprise from government to private owners. As pointed out by Chistyakova and Harrison (1993), the big Russian enterprises have carried out labor policies similar to those of Japanese firms, with lifetime employment and many social services. These elements could be retained in the transformation of these enterprises to Japanese-style management and social organization.

A problem with the reversion of property to former owners is that the present occupiers may resist being moved. Applying Coase (1960), government can facilitate a negotiation between the parties, rather than arbitrarily dictate one common solution for everyone (such as the former owner having the right to evict the tenants, or allowing the tenants to remain at a loss to the owner). Negotiations enable the parties to discover which side faces the greatest cost of not possessing the property. If the parties cannot come to an agreement, they can be required to bid for the right of possession. The side with the greatest bid, reflecting the greatest cost of being dispossessed, would obtain the property, and the other party would receive that amount in compensation.

The collection of economic rents

The third type of land right, to the yield of the land, or the economic rent, can be retained by the government on behalf of the citizens or residents of the jurisdiction. The use of land rent for public revenues was advocated by an open letter to President Mikhail Gorbachev signed by 31 economists, including three Nobel-prize winners, stating that "It is important that the rent of land be retained as a source of government revenue" ("Open Letter to Mikhail Gorbachev," 1991).

The collection of the land rent resolves the controversy in Russia as to whether the land should remain under government ownership or be privatized. As Nicolaus Tideman (1993) notes, the two perspectives can be harmonized, since exchangeable leaseholds, with the rent collected by government, is economically equivalent to the taxation of the rent from private owners, so long as leaseholders have the same rights of use and exchange. Vladimir Aleksandrovich Tikhonov, an author of the 1988 USSR "Law on Cooperatives," argues that the only relationship between the state as owner of the land and anyone working on the land should be the lease relationship (Van Atta, 1989, p. 92). This relationship would transfer power from the state farms to the Soviets or local government.

Once a registry of title holders is established, the government can then assess each lot and record the value in the registry. Besides individual lot records, there should be maps of neighborhoods indicating the land value or rent of each lot, both to facilitate assessments and for public inspection. The value of the land (or of each type of right to the land) should be assessed separately from that of the improvements, such as buildings. Assessments should be updated annually, with monthly adjustments for inflation if the price level is increasing rapidly. An assessment should be based on the estimated market value of the site. If this is not known, then a formula can be devised. Each type of land use can be assigned a basic value per square meter, and factors such as location, infrastructure, proximity to parks, etc., can be assigned weights. Auctions for sites will determine market prices not only for sites in a neighborhood, but also for the various factors (Gwartney, 1990).

The collection of the economic rent can proceed even before the lots are assessed. In Latvia, for example, there is a land tax paid by urban as well as rural possessors. Since the tax is very low (a couple of dollars per year), it can be levied without a prior assessment, since it is much less than the economic rent. A charge levied on land by government takes the form of a tax, but is in substance a user fee, if it is recognized that the rights of the rent are properly owned by the citizens or residents of a community. That portion of charge paid to the government that equals the rent generated by its public goods is a market-type payment for services, in effect a payment for utilities equivalent to the payment for water and electricity.

To maximize productivity, only the economic rent of land should be collected, with no tax applied to the value of the improvements or to any activity taking place on the lot. Any tax on produced goods or production creates disincentives to production, unlike the collection of rents on fixed resources.

Fairness in the assessment of lot values can be maximized by designing several techniques. First, the assessments are public, as is typically the case in the U.S. Secondly, assessments can be appealed by special arbitrators, with further appeal possible in the courts. Any resident should be able to appeal any assessment, so that too-low assessments due to favoritism can be minimized, with some rewards to the agent making a successful appeal, and court costs paid by those making unsuccessful appeals.

Third, title holders may have the option of self assessment. A landowner may set his or her own assessment, with the provision that the lot is then subject to transfer to anyone bidding a certain percentage over the assessment. The owner then has to sell to the bidder or else accept his bid as the assessment, and also pay. fees for prior too-low assessments.

Fourth, the payment of site fees can be postponed, with interest, so that residents on pension can avoid increases, with the balance due paid by the estate (plus interest) , as is done in many U.S. jurisdictions. Site charges can also be postponed when the farm or enterprise has a bad year, or for any reason.

Fifth, there can be limits on the annual increase in site charges for residencies, so that when land increases in value much faster than wages, residents do not suffer radical increases in expenses. The unpaid increase would accrue, just as with the postponement of the payments. The avoidance of extreme increases reduces the likelihood of tax revolts.

While the economic rent of underground minerals, surface sites, and airspace for airplane routes can be determined by market prices and bidding, the use of land as a pollution dump is less subject to market determination, since the damage caused is widespread. Pollution charges can therefore be set as a budget residual. If the total amount collected from other annual rents equals R, and the annual budget equals B, then the total amount of pollution charges is B - R. A country can then be divided into several pollution zones, which can include the atmosphere; seas, rivers and lakes; and soil. Each region is then assigned a percentage of total pollution damage. A list of pollutants can be drawn up for each region, and each pollutant assigned a percentage of the total, based on its relative damage within each region. The pollution emitted by each source, such as factories, automobiles, and agriculture, is measured, and each polluter is assigned an assessment based on its proportion of the total for each pollutant.

With the rents for pollution damage as a budget residual, the total government budget can be paid for from rents and, where feasible, user fees. Transportation, for example, may be paid for partly from the tickets charged for busses and trains, with the remainder from the rents generated by the existence of the transport.

With the government budget fully funded from rent, there is no need to impose taxation on labor and industry, and hence the design of market rules do not need to include any rules of taxation other than the taxation in form of land rent, which as noted above, is in substance a market-based payment. The collection of the various forms of land rent would capture the positive and negative externalities of enterprise.

Tideman (1993) recommends that the rent be collected monthly to provide a continuous stream of revenue, and that there be penalties as well as interest charges for late payments. Owners of land or leaseholds who do not pay after some time period would lose their ownership rights and be evicted. He also recommends that literature be distributed explaining the principles of public finance via rent.

Steven Cord (1992, 1993) suggests adding a land-gains tax to capture rents when the annual rates are below the potential economic rent. He also suggests discounts and penalties for early and late payments, and that contracts for real estate not recorded in the cadastre not be enforceable in the courts. Various localities will wish to have variations on the general theme, although exemptions should be avoided to minimize political opportunism.

Imp1ementation

The implementation of market designs requires cooperation from international agencies, particularly the International Monetary Fund, which has imposed fiscal and monetary policies as a condition for its loans (Guitian, 1992). Policies required by the I.M.F. have included the private ownership of land rent (Redfearn, 1992, pp. 189-90), the taxation of productive effort ("Tax crisis," 1992) , and a restrictive monetary policy (Jeziorski, 1992). In compliance with the IMF requirements, the Latvian government imposed new tariffs on exports and imports ("Latvian Government," 1992) as well as sales and excise taxes and other measures, such as a wage freeze ("Tax crisis," 1992) . The redesign of meta-market rules will require either their adoption by international agencies or else an independent adoption by a country, with the risk of losing some foreign loans.

However, a country that adopts a market design that eliminates taxes and restrictions on enterprise would have a significant competitive advantage so that foreign and domestic investment would very likely spark a boom, providing needed funds both for future growth and for present-day employment.

References

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