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The economic effects of taxes on land: they depend neither on non pecuniary returns nor on capital market imperfections - neutrality
American Journal of Economics and Sociology, The, July, 1997 by Brian L. Bentick
In a recent issue of this journal, Steven C. Bourassa (1992) reviewed the effects on land use of land taxation. His analysis sensibly focused on the "holding cost" and "capitalization" effects of land taxes. These effects obviously raise the pecuniary costs of holding or owning land, and these costs are capitalized into lower land values. Unfortunately, however, his review created the false impression of a consensus that land taxation distorts land use, rather than being generally neutral in its effects, apart from a very special case.
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Quoting a 1966 statement by Netzer, one which was hardly representative of economic thought on this topic by 1992, Bourassa asserted that "the literature on the economic impact of taxes on land suggests that such taxes" are not neutral for three reasons: they will bring land into use by either encouraging owners "to improve their properties to maximize return on investment or to encourage them to sell to someone who will do so" (109), as well as by making "it easier for potential developers to acquire land . . . (111). Bourassa argued that such taxes may in fact be neutral because of two factors which could prevent these holding cost and capitalization effects from having these pro-development effects.
The first factor is that the land is being withheld from development for nonfinancial reasons. He wrote,
The actual extent of the [prodevelopment] holding cost effect would seem to depend on the existence of land which could be developed profitably but is being withheld from development for non-financial reasons . . . . For example, an individual may have a sentimental attachment to his home which prevents him selling his property for redevelopment even though it would be quite profitable to do so. In this case, a holding cost effect would occur only if land taxes more than offset the direct utilities preventing landowners from supplying land for development" (110, my italics).
However "sentimental attachment" simply means that there are non pecuniary or psychic returns from the existing use of the property. And Bentick and Pogue (1989) showed that if the rentals from land use - pecuniary or otherwise - cover the capital costs of developing land for those uses, then uses simply follow the highest rental, regardless of any taxes on land ownership because such a tax does not vary with land use (unless different uses face different tax rates). So while Bourassa usefully reminds us that there may be non pecuniary returns from using land in a particular way, this is quite irrelevant to the holding cost effect of a land tax on land use. His analysis creates the false impression that the neutrality of land taxation is a special case requiring zero or relatively low "sentimental" or non pecuniary returns. Where investors are simply choosing between projects offering immediate pecuniary and non pecuniary returns, a land tax is always neutral.
The second condition that Bourassa considers could lead to land taxes having pro development or efficiency improving consequences is if there are capital market imperfections "preventing developers from obtaining sufficient capital for land purchases for otherwise viable development projects . . ." (111). Were capital markets perfect, when the holding costs of the land tax force some owners to divest, the rate of development does not increase because genuine developers already have all the land that they want at its old cost.
In evaluating this argument two cases should be distinguished. In the first case, redevelopment of land (Use 2) offers an immediate rental in perpetuity which is different from the rental from the alternative, current use (Use 1), whether these rentals are pecuniary or psychic. So the imposition of the capitalized tax means that the value of land in both uses falls by the same proportion, and the relative attraction to the developer of the two uses is not changed by the tax. So even if capital markets were imperfect, provided that the degree of imperfection is constant and unaffected by the tax, the tax will not affect the choice between the projects and will be neutral. In other words, in the case where investors are choosing between projects on the basis of their current rentals, the neutrality of a land tax also holds whether or not capital markets are perfect.
In the second case, Use 2 offers a higher rental than Use 1, but not until some future time T, and this time is too short to allow the capital costs of Use 1 to be amortized, so that it is not feasible to have both Use 1 and Use 2 in sequence: these uses are mutually exclusive. So choosing Use 2 over Use 1 involves leaving the land vacant, or in its existing low rental use (which rental is less than that offered by Use 1), until time T, thus foregoing the higher income from Use 1. In this case, as shown in Bentick (1979), the holding costs of the land tax will reduce the present value of the rentals from Use 2 more than they reduce the present value of rentals from Use 1, because the choice of Use 2 requires waiting whereas Use 1 does not. If capital markets were already imperfect, this imperfection would also have presumably worked against Use 2 since the cost of waiting for Use 2 must be financed at interest rates inflated by that imperfection. Nevertheless, given the degree of capital market imperfection (positive or zero), it is still the case that the tax would further discriminate against Use 2 even if capital markets are perfect.
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