Adequacy of land-value capture for the funding of infrastructure

Prosper Australia Working Paper No.7,* by Gavin R. Putland

Abstract

If an infrastructure project passes a cost-benefit test, the uplift in land values in areas serviced by the infrastructure will exceed the cost of the project, in which case the cost can be covered by reclaiming part of the uplift in land values, leaving the rest of the uplift as a net windfall for the affected land owners. Every piece of infrastructure that is worth building can be funded in this manner, leaving no one worse off. Every current infrastructure problem — including water, roads, public transport, state schools, and internet access — could be solved if a sufficient fraction of the uplift in land values caused by the solution were reclaimed in order to pay for the solution.

Contents

1.  When Californians had the Wright stuff

2.  Theory

2.1  Tapping benefits to cover costs
2.2  The role of user charges
2.3  Self-hypothecating taxes
2.4  No deadweight
2.5  Private finance?
2.6  No losers

3.  Examples

3.1  Water
3.2  Railways
3.3  Schools
3.4  Underground power
3.5  Broadband internet access

4.  Implementation

5.  Conclusion

References

1.  When Californians had the Wright stuff

In 1923, the farmers in the Irrigation Districts of Modesto and Turlock in California's Central Valley celebrated the completion of the original Don Pedro dam, which was then the tallest gravity dam in the world (86 metres).

How much did the state government spend on this project, whose benefits were confined to a small region of the state? None! How much did the federal government spend on it? None! The entire project was conceived and funded by the two Irrigation Districts. The up-front cost was met by selling bonds, which were repaid over time by recurrent property taxes imposed only within the Districts.

Did the local politicians who administered this scheme suffer any electoral backlash? Only for not moving fast enough! The directors of Modesto, who allegedly slowed the negotiations with Turlock, had two of their number recalled by the voters, and were confronted by at least two public meetings of angry farmers telling them to get on with it [1]. The affected land owners supported the method of financing because they understood that the increase in profitability of their farms would outweigh the associated increase in their tax bills. This outcome was guaranteed because the taxes were assessed on the market value of their land: their taxes would not increase unless their land values did, and their land values would not increase unless, in the judgment of the market, the owners were better off in spite of the tax implication.

So much for the modern theory that property owners in general, and farmers in particular, are implacably opposed to land tax.

The legislation that created California's Irrigation Districts was known as the Wright Act. Its history is summarized by Prof. Mason Gaffney [2] as follows:

The Wright Act dated from 1887, and sputtered along fitfully until in 1909 the California Legislature amended the enabling legislation to limit the assessment in all new districts to the land value only. It also let old districts do so by local option (Cal. Stat. 1909, p.461). The old districts soon did: Modesto in 1911, Turlock in 1915...

In 1917,... the California Legislature made it mandatory for all Districts to exempt improvements... They then grew to include over four million acres by 1927, and to dominate American agriculture in their specialty crops... Albert Henley, a lawyer who crafted the modified District that serves metropolitan San Jose, evaluated them thus: "The discovery of the legal formula of these organizations was of infinitely greater value to California than the discovery of gold a generation before. They are an extraordinarily potent engine for the creation of wealth." ... They catapulted California into being the top-producing farm state in the Union, using land that was previously desert or range.

Then Gaffney complains:

One searches in vain through academic books and journals on farm economics for recognition of this, the most spectacularly successful story of farm economic development in history. What references there are consist of precautionary cluckings focused on attendant errors and failures. "Economic development" theorists neglect it altogether, as though California's commercial farming had sprung full blown from a corporate office, with no grass roots basis, and no development period. It is as though the clerisy were in conspiracy against the demos, under some Trappist oath against disclosing what groups of small people achieved through community action, and through the judicious application of the pro-incentive power of taxing land values.

2.  Theory

2.1  Tapping benefits to cover costs

The market cannot value the benefit of infrastructure except through the price of access to the infrastructure: market value equals price of access. But the price of access has two components: the obvious one, namely the charges (fares, tolls, etc.) payable for actual use of the infrastructure; and the hidden one, namely the price of living or doing business in a location where the service provided by the infrastructure is available, as opposed to a location where it is not.

In practice, access to a location means access to real estate in that location. Therefore locational value is reflected in rents and prices of real estate. In particular, it is reflected in the rents and prices of land. It is not reflected in the values of buildings erected on the land, because building values are limited by construction costs. But it is reflected in land values, because land has location (and therefore locational value) even if no buildings yet stand upon it. Part of the locational value of land is conferred by the planning system, which determines the uses to which land in a given location may be put, including permitted heights of buildings. To allow for this fact and for the related phenomenon of strata titles, we say that locational values are reflected not only in land values but more precisely in site values, where a site is a piece of ground or airspace, including any attached rights to build on that ground or into that airspace and to use the ground or airspace for particular purposes, but excluding any actual buildings or other artefacts; thus "site value" is a slight generalization of "land value".

So the "hidden" component of the price of access to infrastructure is the uplift in site values caused by provision of the infrastructure. Moreover, the benefit of the infrastructure to the public (as opposed to the provider, i.e. the government) is net of charges for actual use; that is, it is equal to the "hidden" component of the price of access. Therefore:

The net benefit of infrastructure to the public is the total uplift in site values caused by the infrastructure.

It follows that the cost/benefit ratio of an infrastructure project is simply the cost/uplift ratio. If the "cost" is understood as the cost to the provider, which is net of charges for actual use, then this cost/uplift ratio is the fraction of the uplift that must be recovered through the tax system in order to pay for the project. And if the project passes a cost-benefit test, this fraction is less than 100%. Thus we reach the following conclusion, which has the status of a theorem:

Any infrastructure that passes an economic cost/benefit test can be financed by a tax collecting less than 100% of the uplift in site values caused by the infrastructure, the rest of the uplift being a net windfall for the site owners.

Alternatively, if a certain fraction of every uplift is reclaimed through the tax system, infrastructure projects whose cost/benefit ratios are equal to that fraction will be self-funding, while projects with lower cost/benefit ratios will be more than self-funding, yielding a net contribution to revenue which may be used for, e.g., tax cuts, while the remainder of the uplifts is a windfall for the property owners.

2.2  The role of user charges

The two components of the price of access to infrastructure are inversely related: if one must pay more for actual use of the infrastructure (e.g. through fares and tolls), one will be inclined to pay less for the mere opportunity to use it, i.e. for real estate in locations where the infrastructure is available, so that site values in the affected locations will be less.

But how should the price of access be divided between the two components? Under conditions of diminishing marginal utility, users seeking to maximize their own welfare will increase their use until the marginal utility falls to the price of use, whereas the common welfare is maximized if use rises to the point where marginal utility falls to marginal cost. So if the actual level of use is to maximize the common welfare, the price of use must be set at the marginal cost. If the average cost exceeds the marginal cost (as tends to be the case with infrastructure), then the excess must be funded from some other source. The logical source, as we have seen, is the uplift in site values.

2.3  Self-hypothecating taxes

The Californian experience illustrates a point familiar to modern opinion pollsters, namely that voters will support a tax if the revenue is hypothecated (i.e. reserved or "earmarked") for programs yielding sufficient benefits to the taxpayers. But all such arrangements raise a problem: How does one convince the voters that the revenue will be spent as promised?

In California, part of the solution was to limit the authority of the "government" that levied the tax. The Irrigation Districts resembled local governments except that they were responsible solely for water. Later their authority was expanded to include the other type of infrastructure commonly associated with dams: electric power. But their authority was still restricted to infrastructure. So, when the Irrigation Districts collected property taxes, they were certain to spend the revenue on infrastructure because they had no authority to spend it on anything else.

But a tax levied at a fixed rate on the values of sites, even if imposed by a government with otherwise unlimited powers, provides another safeguard. The site owners know that their tax bills will not increase unless their site values increase — if not due to infrastructure, then at least due to some other cause. At the same time, the government knows that its revenue will not increase unless site values increase — e.g. because the extra revenue is spent on infrastructure (or amortizing the cost thereof). If the tax ultimately recovers a fraction 1/x of all real increases in site values, the government will have both a fiscal incentive and a political incentive to invest in any infrastructure project that increases site values by more than x times the cost of the project, because such a project will pay for itself (and more) through part of the uplift in site values that it causes, while the affected property owners will retain the rest of the uplift as an after-tax benefit by courtesy of the government.

In short, a tax on uplifts in site values is not a means of raising revenue for promised projects that may or may not proceed as promised. Rather, it is a means of making desirable infrastructure projects pay for themselves if and only if they go ahead.

2.4  No deadweight

When we say (above) that the minimum benefit/cost ratio for a self-funding project is x, we refer to a project which is self-funding in the fiscal sense — that is, self-funding from the viewpoint of the government alone — when a fraction 1/x of all real increases in site values is reclaimed by taxation. If site owners are to be net winners, this fraction must be less than 100%, so that x>1, But under the present tax regime, when governments set a minimum benefit/cost ratio greater than 1 for projects that qualify for funding, they do so for an entirely different reason.

Taxes reduce the returns on the taxed activities, causing otherwise viable transactions, and hence otherwise viable enterprises, to become unviable. The cost to the economy of these lost opportunities is called the deadweight cost of taxation. It is also called the excess burden of taxation — the word "excess" meaning "over and above the actual tax paid" — and is conventionally expressed as a percentage of the tax paid.

For example, the U.K. Treasury officially estimates the excess burden at 30%, meaning that the total cost of taxation to the private sector is 1.3 times the actual tax paid. On that basis, if a proposed infrastructure project is to be funded by taxation, one would have to multiply the cost by 1.3 when assessing the benefit/cost ratio as seen by the private sector, or require that the raw benefit/cost ratio (calculated from the unadjusted cost) must exceed 1.3 (not 1.0) if the project is to be funded. The U.K. Dept. of Transport takes the latter approach, using raw benefit/cost ratios. But when we look at the guidelines given by the Dept. of Transport concerning the likelihood that projects with particular benefit/cost ratios will be funded, we find that the policy is based on an excess burden more like 100%: if we are to be reasonably confident that a project will be funded, its raw benefit/cost ratio must be at least 2. (See [3], pp.29–31.)

However, when a project is funded by a tax on the ensuing uplift in site values, the tax cannot reduce the return on the taxed activity, because there is no taxed activity: for each taxpayer (i.e. for each site owner), the uplift that triggers the tax liability is not caused by anything done by the taxpayer; therefore it cannot reduce the return on anything done by the taxpayer, and cannot dissuade the taxpayer from doing it. In other words, our proposed method of funding has no excess burden.

In summary, our minimum benefit/cost ratio ("x") achieves a far more ambitious goal than the minimum cost/benefit ratios presently required by governments under conventional methods of funding. Under our proposal, there is no excess burden, so the "raw" benefit/cost ratio is the benefit/cost ratio seen by the private sector, and the purpose of inflating the required benefit/cost ratio is to ensure that the project is self-funding not only for the private sector, but also for the government. But under conventional methods of funding, the purpose of inflating the required benefit/cost ratio is to compensate for the excess burden, so that the project pays for itself from the viewpoint of the private sector in spite of the excess burden; the possibility that the project might also be self-funding for the government is simply not entertained.

2.5  Private finance?

The excess burden of taxation might be used as an argument for private financing of infrastructure by schemes such as those known in the U.K. as "private finance initiatives" (PFIs) and in Australia as "public-private partnerships" (PPPs). Such an argument would be spurious on two counts. First, as we have just seen, it is quite possible to devise taxes with no excess burdens. Second, because private providers of infrastructure have little or no ability to tap the "hidden" component of the benefit of infrastructure, namely the uplift in site values in the serviced areas, they attempt to amortize their capital costs entirely from user charges (e.g. fares and tolls). So the charges on users are high, and utilization is consequently low, with the result that the providers often have to be rescued by the taxpayers. Low utilization defeats the purpose of the infrastructure, while taxpayer-funded subsidies, guarantees, and bail-outs defeat the alleged purpose of private finance.

The essence of our funding proposal is that the party financing the capital cost of the infrastructure must claim a share of the resulting uplift in site values. In theory, this method works even if the party financing the capital cost is not a government. In practice, however, only governments are likely to have all the necessary authority. This of course does not mean that private entities cannot be involved in the design, construction, operation, and support of infrastructure; on the contrary, in so far as these things are contestable, they should indeed be contested by private entities in order to exploit the efficiencies encouraged by competition. But it does mean that governments, using their powers of taxation, must take the initiative.

2.6  No losers

Under a recurrent tax on the values of sites, the owners' tax bills do not increase unless their site values do, and the site values do not increase unless the owners, in their capacity as owners, are better off in spite of the tax implication. This guarantees that the owners cannot lose in consequence of increases in their site values that occur while the tax system is in place. But it does not of itself guarantee that site owners do not lose in the transition to that tax system. The latter guarantee is given, however, by a system in which the increase in each owner's tax bill since the last year of the former system is apportioned to the increase in the site value since the last year of the former system. This outcome can be achieved by attaching an appropriate tax-free threshold value to each site [4].

3.  Examples

The arguments in the preceding section are quite general, making no assumption about the nature of the infrastructure except that its availability is a function of location. Nevertheless it is instructive to consider some specific types of infrastructure.

3.1  Water

When politicians are looking for excuses not to proceed with a proposed dam, especially in an urban or near-urban area, they emphasize the high cost of compensating property owners whose land would be submerged, but say nothing about the simultaneous increase in value of surrounding land that would remain dry. That land would acquire waterfront or near-waterfront status, and access to waterfront is one of the two most salient locational attributes that add value to land (the other being access to the city centre). The same land would also gain market value due to the reduction in the supply of dry land in the vicinity. In rural areas, where land holdings tend to be larger in area, typically only part of each holding is submerged by a new dam, in which case the increase in value of the non-submerged part is typically greater than the previous value of the submerged part, so that no compensation needs to be paid. But in urban and semi-urban areas, where a new dam would submerge numerous entire properties while adding value to numerous others, the possibility of harnessing the added value falls on a fiscal blind spot, with the result that compensation for owners of submerged properties is deemed to be too expensive.

Often the real reason for not proceeding with a proposed dam is the anticipated electoral backlash from those whose properties would be submerged. But the backlash is due to inadequate compensation for site owners adversely affected by public projects. And the compensation is inadequate because governments fail to tax the owners of other sites that increases in value in consequence of the same projects. If a project creates a net public benefit, owners whose sites are resumed or devalued should be able to share in the benefit — through over-compensation for their losses. The fundamental reason why the benefits of public projects are not shared in this way is that governments fail to reclaim a sufficient fraction of the uplifts in site values caused by the same projects — in other words, that those site owners who happen to be the immediate beneficiaries of public projects are allowed to keep all or nearly all of the benefit, and not merely a fair share of it. But those same site owners are ultimately losers because numerous other public projects that would add value to their sites are thwarted for want of funding.

Perth, the Australian city with the most bubbly property market, also happens to have the least severe water restrictions of the "big five" cities. While there may not yet be any significant connection between those two facts, differences between water restrictions and between prospects for future supply must exert some influence on locational decisions and therefore on locational values. And the locational decisions of industry, which affect values of commercial and industrial sites, influence locational decisions of current and prospective employees, which affect values of residential sites.

But the real economic value of dams, as measured by their real influence on site values, will be seen if and when large areas of suburbia run out of water: the owners of the affected properties will discover that they can neither let them to tenants, nor sell them except to long-term speculators at fire-sale prices, and water will become the main driver of inter-city migration and the associated trends in site values. Then we might belatedly see some realistic assessments of the benefit/cost ratios of dams, and of the political feasibility of tapping the benefits in order to defray the costs.

At the time of writing, we cannot avoid noting that the Premier of Queensland has recently championed a variant of the Bradfield Scheme — the 70-year-old proposal to divert part of the flow of Queensland's coastal rivers into the Murray-Darling system. Without taking a position for or against this proposal, we must point out that all assessments of its economic feasibility are hopelessly biased (to the negative) unless they account for the possibility of tapping the consequent uplifts in values of inland agricultural land.

3.2  Railways

I landed at Dover after a choppy crossing of the Channel in 1962, and for the next 40 years I paid my taxes to Her Majesty's Treasury... I did not dodge my obligations to the public purse. After all, I was married, raising two children and using the public services; so I was happy to pay my share of the costs of the schools and hospitals that my family needed.

Then, as the millennium was dawning, a miracle happened... Taxpayers generously funded the extension to the Jubilee Line, one of London's Underground lines. Two of the stations were located close to office properties that I own. Those two stations raised the value of my properties by more than all the taxes that I had paid into the public's coffers over the previous 40 years.

A nice windfall for this colonial boy.

So wrote Don Riley in his foreword to Wheels of Fortune [3]. Earlier, in his own book [5], Riley quantified the total uplift in site values caused by the Jubilee Line Extension. Taking five of the ten underground stations as a sample, and drawing on available valuations and sales records, Riley estimated the average increase in site values per unit area within 400 yards of each station (1 yard=0.9144m), then between 400 and 800 yards from each station, and then between 800 and 1000 yards from each station, converted the averages to totals, added the results, and extended them to the other stations. He concluded that the railway, which cost the taxpayers £3.5 billion, had increased site values by a conservative £13 billion. If 27% of that uplift in site values had been reclaimed through the tax system, leaving the other 73% for the lucky property owners, the Jubilee Extension could have paid for itself without burdening any other taxpayers.

Meanwhile, in other parts of London, the long-promised Crossrail and Chelsea-Hackney projects (the latter also known as Crossrail 2) remain stalled because of the alleged difficulty of financing them. The high cost of the recent Jubilee extension is even cited as contributing to the delay! The real obstacle is the insistence that local property owners must get 100% of the ensuing uplift in site values; 73% is apparently not good enough. To date, the consequence of this attitude for property owners near the Crossrail and Chelsea-Hackney routes is that, instead of receiving 73% of a multi-billion-pound uplift, they have received 100% of nothing.

Riley could not help noticing that if property owners were obliged to give back a sufficient fraction of their unearned windfalls to pay for the public projects that caused them, more such projects would proceed, so that property owners would get more windfalls. As a successful property investor himself, he found himself embarrassed not only by the immorality of his fellow investors' position, but also by its stupidity.

Riley's example is most directly applicable to underground railways. For surface railways, the uplift in site values is lower because of noise and the restricted movement of non-rail traffic across the line. But of course the capital cost is also lower. And our general theorem — that any infrastructure passing a cost-benefit test can be funded out of the associated uplift in site values — continues to apply.

3.3  Schools

If the government can add value to your home by making it easier to commute in a particular direction, e.g. by building a railway within walking distance, then it can add even more value by eliminating the need to commute in a particular direction — e.g. by building a school within walking distance. So what we have said about funding of railways applies a fortiori to the funding of schools.

The quality of the school also counts. Riley [5, p.14] quotes a study [6] on two highly-regarded state schools in Coventry, which found that being in the catchment area of a "desired" school added between £700 and £1400 per year to the mortgage cost of a home. That would have been a substantial contribution to the total per-student tuition cost, let alone the per-student cost of whatever advantage the "desired" school was perceived to have.

So a "free" state school is not free. The admission charge is the uplift in site values caused by the presence of the school, and is payable not to the school or to the government that provides it, but to the owners of sites in the catchment area.

The usual inverse relationship between user charges and uplifts in site values continues to hold. Thus a "free" state school raises site values more than a fee-charging private school of comparable quality. But the argument for optimizing use of the service by marginal-cost pricing is not applicable here, because there are only so many people who can potentially participate in basic education, and it is generally accepted that the optimum participation rate is 100%.

3.4  Underground power

The reliability of electricity supplies and the safety of electricity consumers can be improved by placing local power lines underground in order to protect them from lightning, wind, fire, trees, runaway vehicles, etc. In new suburbs, the provision of underground power lines can be imposed on developers as a condition of development. But in established suburbs, relocating ("sinking") the power lines is more problematic — unless one taps the resulting uplifts in site values.

Between 1983 and 1997, the City of Subiaco (inner Perth, WA) sank the power lines on about a third of its streets at a cost of $3000 to $4000 per lot, with the result that property values increased by about $10,000 per lot [7]. To make this project pay for itself, the City needed to recover at most 40% of the uplift through the rating system. Unfortunately it did not: ratepayers who received none of the benefit contributed to the cost.

In principle, the sinking of power lines could be funded by a general scheme for tapping increases in site values. In this case, however, because the service in question is specific, highly visible, and imputable to particular properties, it might be politically easier to finance the project with a special-purpose lump-sum levy which would be payable once in respect of each affected property, deferable until the next transfer of title, and adjusted (during deferment) in line with the overall trend in property values. Provided that the levy payable at the time of sale is less than the increase in the sale price due to the project, every affected property owner receives a net windfall.

3.5  Broadband internet access

When Telstra makes ADSL access available in some areas but not others, it raises site values in the former areas but not the latter. The effect may not yet be statistically significant, but will surely become so as competitive pressures make broadband access more important.

At the time of writing, the Federal Opposition has just promised to spend $4.7 billion, including up to $2.7 billion drawn from the Future Fund, on a national fibre-to-the-node broadband network, which it claims will cover 98% of the population. As always, if this project passes a cost/benefit test, its benefit will be manifested in site values in locations where the service is available (these locations covering a small fraction of the national land area, even if they include 98% of the population). If those increases in site values were used as a source of funding, it would not be necessary to raid the Future Fund.

4.  Implementation

There are two simple methods by which an Australian State government could reclaim a significant fraction of uplifts in site values, while ensuring that property owners cannot lose in the operation of the new system or in the transition from the old system to the new. The two methods can be used together.

The first is to replace all recurrent property taxes, including rates, land tax, and special-purpose charges that fall on property owners per se, with a single recurrent tax on site values, the tax-free threshold for each site being chosen so that, in the transition from the old system to the new, there is no increase in total recurrent property taxes payable in respect of that site. Deferment provisions avoid the need to pay tax on unrealized gains.

The second is to replace all property transfer taxes, including stamp duties and development levies, with a single transfer tax apportioned to the increase in the site value since the last transfer, with the proviso that if the property was acquired under the old system, the seller shall have the option of paying tax as if the property had been sold and bought back on the last day of operation of that system.

Both methods, together with their effects on housing affordability, are described in more detail in Working Paper No.4. More ambitious proposals, which are potentially applicable and both Federal and State level, are floated in Working Papers 2 and 6.

5.  Conclusion

Any infrastructure project that is economically justifiable can be funded out of the uplift in site values caused by the project.

Calculations purporting to show that a particular public project is "uneconomic" or "unviable" are invalid unless they account for uplifts in site values.

If a certain fraction (less than 100%) of all real uplifts in site values were reclaimed by taxation, every public project with a cost/benefit ratio not exceeding that fraction would become self-funding or revenue-positive, but would still deliver net windfalls to the affected site owners. Property owners would gain from such an arrangement, because they would receive uplifts in site values from projects that would not otherwise proceed. Furthermore, such an arrangement can be put in place without increasing anyone's tax burden in the transition from the old system to the new.

When projects are funded in this manner, there is no need to inflate the required benefit/cost ratio in order to allow for the excess burden of taxation, because there is no excess burden.

In short, there is no excuse for a continuing "infrastructure crisis".

References

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