China's Policy Checkmate

July 27, 2010
By

Interview with Xulin Dong
May 2010

DX: You have strongly advocated the use of taxation as a most effective and desirable way to prevent real-estate bubble. Now in the Chinese media there’s a good deal of discussion about the need to re-design China’s real-estate tax regime. In particular, about the merit of a US type of property tax. So what are the key elements of a good real-estate regime?

MH: For starters, there is confusion about just what a “land tax” is. China has a policy of granting long-term leases, for up to 70 years for residential property. The price charged for these leases is NOT a land tax. It gives security of land title – that is, of land tenure. On the assumption that a building will have a useful life of 70 years, this assures a prospective builder or real estate developer that he will not simply be charged for what he puts up – which would amount to compensation.

So the existing leasehold gives him security. Americans and Europeans, for example, hold title to a property until they sell it. But they still have to pay taxes on the property’s assessed valuation, which changes each year according to the market. The problem with China is that it does not collect ANY tax – only the quit small initial title charge.

A tax on the land’s rental value – which usually determines the property’s market value – cannot be set in advance. It is set by the market, and changes from year to year. It usually rises, but after a financial bubble it may plunge. If governments follow classical liberal policy and minimize bank credit, property prices remain stable, as in Germany. And if the governments collect the “free lunch” of land rent, property prices will remain stable – and so, bank loans will not bid up the price, because the NET RENT – the rental income (or the equivalent value to homeowners) LESS the public tax will not leave a “free lunch” over to be capitalized into interest charges to be paid to banks on larger loans.

There is no economic way that many years’ rent can be paid in advance. It can only be paid on an annual pay-as-you-go basis, out of income as earned or out of the value of a home to its owner-occupant.

The American property tax is not an ideal classical real estate tax, because it taxes buildings as well as land. This penalizes builders who develop property. It is in the interest of China to have as much construction as possible. At a point, if this increases the value of living in a particular neighborhood or district, it will make the land site more valuable – over and above the building’s cost and normal profits on the builder’s capital expenditure. So to encourage building but not provide a “free lunch,” only the land should be taxed, not buildings.

This is why many American cities now have a “two rate property tax,” with most of the tax levied on the land and only a smaller amount levied on the building.

There is a long history of economic theorizing about this. In fact, classical political economy was developed largely to deal with the problem of economic rent and how to tax it – not only land rent but also monopoly rent and financial charges for interest and other fees. These three forms of revenue were called rentier income – and are made by an “idle class” “in its sleep,” as John Stuart Mill expressed it.

The essence of classical economics was to defend the policy of taxing the “free lunch” of economic gains that are NOT created by an investor’s own labor, expenditure or enterprise. This free lunch was defined as economic rent, and there were three major categories of this rent: groundrent for land, monopoly rent for monopolies (with no competition), and interest or other financial charges levied by banks as a result of their monopoly of credit creation and money-handling.

According to the economics of the “original liberals” from John Locke in the 1690s to the Physiocrats and Adam Smith (1776), John Stuart Mill and Progressive Era reformers, the proper source of taxation in the case of real estate should be the land’s site value.

Real estate developers have a right to make a normal profit on the capital invested in buildings and other improvements. But the land is supplied by nature, and its site value is created by the economy at large – by the city or other government authority that provides transportation (roads, subways, bus lines), water and sewer facilities, phone lines, and especially in America, public schools; and also by generally economic conditions that makes “good neighborhoods” the most important factors defining one’s status – i.e., status symbols.

XD: What pitfalls should China take care to avoid in redesigning its tax system?

MH:China needs to make sure that the land’s site value – which rises in response to prosperity – is collected by the government, not by bankers (and especially, not by foreign bankers with the “free” privilege of creating credit and charging interest as a “free lunch”).

The main opponent to a good tax policy is not only real estate developers, but the bankers behind them. The bankers realize that whatever site-value the tax collector leaves “free” will be paid out as interest. And if this “natural tax base” is paid out as interest, the government would have to tax labor and the things it buys, by an income tax and sales taxes or value-added taxes. That would raise the cost of living and doing business, and hence would make China’s economy less competitive. But by taxing away the “free lunch rent” that otherwise would be pledged to bankers, China’s government will hold down property prices (and not raise the rental payments, which are set by market conditions).

The important theoretical point to understand is that taxes are paid OUT OF market rents. They do not RAISE rents. They do not raise the price of home ownership. But they do leave less “free lunch revenue” to be capitalized into bank loans. So the public sector, which creates rental value in the first place, receives this value back in taxes rather than letting the banks privatize it.

XD: Will a progressive capital gain tax alone do the trick of stopping excessive speculation? Is an annually assessed property tax essential?

MH: A capital gains tax usually is only collected when a property is sold. However, American cities re-assess the market value of real estate every two years or so. (It takes two or three assessors about three months to assess an entire city.) The aim of a good tax system is to tax the rental value of a site – the land itself. So if there is a nice new building next to a parking lot, both properties will pay the same property tax (if the land area is the same).

The aim is not to penalize a developer for putting up a building (which is a good investment), but to penalize slumlords or property speculators who UNDER-develop their properties, waiting for land values to rise. A tax on the land’s rising market value will induce the hoarder to sell to someone who WILL build up the site to its current economic potential.

XD: It seems a bit counter intuitive: most people desire tax benefit as far as home-ownership is concerned.

MH: There is a popular misconception that fails to put taxes and bank interest in perspective. Bankers have promoted the confusion that a lower property tax will reduce the carrying charge of owning a home. What they don’t explain is that if the government leaves the rental value uncollected – that is, “free” – it will be “free” to be pledged to pay interest to a bank. So the homeowner (or commercial investor) will pay the same rental value in either case – namely, the market rental value for that site. But whatever the government taxes will be unavailable to be paid to the bankers. So there sill be less rental income to capitalize into a bank loan – and homeowners (and commercial investors) will not bid up property prices so high.

In this way, China will avoid the real estate bubble that resulted from property-tax cuts in the United States. That bubble was really a financial bubble stemming from “easy credit.” It was sponsored by the banks, because they ended up with all the rising property valuation of cities and suburbs – leaving local governments squeezed, so now the United States is left with a state and local fiscal crisis as well as a “negative equity” real estate foreclosure crisis.

Charts of the tax shift of state and local taxes off property onto labor – from a 66% of local tax receipts coming from the property tax in 1930, to only about 16% today are readily available.

XD: There is, prima facie, an apparent contradiction here: the government, in US in post war period, and today in China, have a stated policy of promoting home – ownership by tax benefit; it appears to work for a while – in the case of China, the urban housing ownership rate has gone up dramatically since onset of reform in 1998…

MH: People (and commercial investors) only seem to gain from low property taxes if they fail to realize that the banks will increase their loans to absorb whatever the tax collector leaves uncollected. The motto among American real estate investors is, “Rent is for paying interest.” They mean, NET rent, AFTER taxes. So the higher the proportion of land rent, the less interest will be paid. But the sum of taxes PLUS interest will remain the same.

Tax “benefits” are passed on to the banks. “Homeowners” are only the vehicles for this transfer of revenue from the government to the banks. What they “save” in taxes they PAY in interest.

The main policy objective today should be to save China’s home buyers from being reduced to debt peonage as is becoming the case in the United States. To buy a home, many Americans have to go into a lifetime of debt, working thirty years to give all their income over basic break-even needs to the bank. And during this period the bank may get twice as much in interest as the seller got for the house that was sold. So bankers become the richest class – and use their wealth to influence government to cut taxes on the higher income brackets even more.

XD: In the US, I understand that the tax exemption on mortgage interest payment had been a cornerstone of the post war governments’ policy to promote home-ownership; and it had worked very well for a couple of decades.

MH: Tax favoritism for mortgages only “helps” homeowners have more “free” income to pay to banks. When property taxes are cut, property prices rise – because buyers have more rent to pass on to the banks.

So we are brought back to the basic economic axiom: Whatever the tax collector relinquishes is available to be paid to the banks as interest. Homeowners are being tricked by junk economics – sponsored by banking public-relations specialists – not to recognize this.

XD: Both the government and people say they support tax benefit as a means to promote home-ownership. Your theory is that property tax and capital gain tax in the long run actually make housing more affordable and therefore wider home-ownership. Is there ample empirical evidence to support your theory in the history of American home-ownership? Can you elaborate?

MH: Workers in countries such as Germany that have much tighter bank regulations – and more communally owned housing – pay only about 20% of their wages for housing. It is twice that in the United States. The real estate bubble – promoted by shifting taxes off land onto labor and capital – has been a major factor pricing American labor out of world markets, making the economy less competitive. For example, the comparison of the neo-liberal period with the preceding periods where there was a better tax system.

XD: The major culprits now identified and vilified by most commentators, the real estate developers and the local governments, are publicly keeping a low profile; but it is believed that they are feverishly lobbying the central governments by conjuring up the specter of economic crisis and social unrest resulting from the collapse of real estate industry.

MH: Writing down bad mortgage loans would not cause unrest. It would be welcomed. But in the United States, predators are more activist than victims. The vested interests seek to defend their special privileges and free lunch. Victims are less politically activist and “restive” than predators.

XD: What would be your response to such an argument against imposition and collection of property tax and capital gain tax?

MH: All economic logic for the past two centuries says that a tax on land rent and other economic rent is the “least bad” tax. This is basic Economics 101 analysis. Taxes on labor and capital raise their price. Taxes are paid OUT of rent and capital gains, and thus leave less to be financialized.

XD: Progressive capital gain tax, how high should it go?

MH: It should capture all the rising land value. In practice this means the rise in property values, because buildings don’t rise in value – the wear out.

XD: What should be the principles or parameters to be used to guide the setting of an optimal tax rate scheme? If 1% in the post soviet countries is considered too low, as indicated in your doctrinal paper, what is the property tax rate in New York?

MH: The tax rate in New York is about 1% to 1.5%. But this failed to capture the rapid increase in site values. And the New York property tax is levied on buildings, not just on land. So parking lots and slums or other undeveloped properties pay much less tax than built-up properties. This leads to an underutilization of land.

This is not an economically efficient way to do things. What should belong to the public is the land’s rental value, which tends to rise over time – and be paid to banks if it is not taxed.

The rental value cannot be paid in advance for two reasons. (1) It cannot be known, because the rental value depends on general economic conditions, and on local government spending. Only the market can set rents, from year to year. (2) paying the rental value in advance would be impossibly large.

If the aim is to get developers to build up sites, they should get a fair return on their capital investment in buildings and other capital improvements. But they should not get the free lunch of rising land prices over the longer term.

As the neighborhood and economy grows more prosperous – and especially as the government provides better and more convenient transportation and civic improvements – the rental value will increase. It rises not because of the landlord’s own spending, but because nature supplies land sites without cost.

Land sites – along with subsoil natural endowments, and the economic rents of natural monopolies –should be China’s natural tax base for three reasons. (1) It will make housing more affordable – and thus keeps China’s economy more competitive. (2) it will hold down debt to bankers. Because whatever the tax collector relinquishes is “free” to be paid as interest. So home buyers would pay just as much rental value in any case. The key is who will get this rent: private banks or the government. (3) It will save government from having to tax labor and capital, which would increase the cost of living and doing business, and thus save the economy from losing its competitive advantage.

In sum, a land tax will save labor and industry from having to be taxed. A land tax will hold down real estate prices too. This will keep the economy more competitive, by keeping its financial and real estate overhead low. A land tax will free China simultaneously from personal and business income taxation and from interest payments as untaxed land’s rental value is capitalized into bank loans and paid as interest rather than to the public sector.

DX: In the Post-War period the United States twice successfully shifted economic crises to Europe and Japan. How likely is it that the United States will succeed again to come out relatively in better shape by shifting the Crisis to other countries? Is the current woes in Greece and Euro-zone in General another evidence of the ability of Dollar Hegemony to shift crisis? If So, can you explain the mechanics?

MH: The euro was misconceived from the outset – largely by following the views of Chicago monetarist Robert Mundell. And the Maastricht and Lisbon agreements were the results of neoliberal political policy invented in the United States to promote the financial interests. But Europe basically bears responsibility for screwing up – by supporting the vested interests and an impossible pro-financial policy that never had any chance of succeeding. So all that has happened was inevitable. Many people warned that a true “United States of Europe” would need a democratic European parliament, not an EU bureaucracy run by bank lobbyists. What you are seeing in Greece and the PIIGS is the result of a self-defeating pro-financial, anti-labor tax policy that has painted economies into a debt corner.

Speculators are simply feeding on the corpse. The United States never opposed the euro. They saw Europe as keeping its foreign-exchange reserves in the form of loans to the U.S. Treasury, which was fine as far as U.S. economic strategists are concerned.

DX: Let’s talk a little bit more about Europe. Recently an increasing number of Chinese intellectuals, disillusioned by USA, have turned to Europe as a model for economical and social development. But you have been very critical of Europe for failure to defend Europe’s interest against American Hegemony and for embracing neoliberalism. You have said that Europe is not ‘rising’, the only economy that is rising is China. Can you explain how Europe could have done differently in response to this financial crisis in general and, in particular, with regard to the current mess in Greece?

MH: Europe has applied U.S. neoliberal policy even more than the United States has done! The EEC began in 1957 as a social-democratic move against nationalism. But the Maastricht and Lisbon agreements have turned the European Union into a neoliberalized, financialized right-wing government. It is turning tax policy against labor, and is making itself less competitive. And the “Old Europe” countries treated the post-Soviet “New Europe” countries as colonies – as markets for their surplus agricultural and industrial exports, and for their banks. Today these post-Soviet economies are defaulting and the bad right-wing economic planning by the banks is leading to a financial crisis, wrecking the European economies.

European governments need not have borrowed from banks. They could have monetized their own debt. But the vested interests that are left over from feudal times – the landed aristocracy and the banking class – have fought back against the reforms early in the 20th century, to mount an economic Counter-Enlightenment. The population no longer can afford a good education. Emigration is stepping up. Labor’s wages are being squeezed. Governments are running deficits as result of not taxing wealth, but are taxing labor and raising its price, making the products of labor uncompetitive in world markets.

XD: What is your take on the current effort of Obama administration to carry out financial reform? How about the key ideas for financial reform that are being discussed by mainstream economists in US and elsewhere, such as the FAT tax? What is the key issue of financial reform that the mainstream economists in general and Obama’s plan in particular fail to address?

MH: There is no real “reform” in the United States. What is called ‘reform’ is as much a travesty of the word as post-Soviet neoliberal ‘reforms’ were. Bank lobbyists have blocked political reform, by translating their economic power into political power via campaign contributions and lobbying – and the promise of high-paying jobs in the private sector for politicians who serve their interests in office. (This is what the Japanese call “descent from heaven.”)

So American voters are very disappointed in President Obama. He has appointed the same de-regulatory officials that made the Clinton administration so bad: Larry Summers, Tim Geithner and other “Rubinomics” neoliberals.

Instead of rolling back bad mortgage debts and other debts to reflect the ability to pay, the Obama administration has bailed out the banks for their losses – leaving the debt overhead in place. This means that more and more income needs to be paid to creditors, leaving less available to be spent on goods and services. The result is a squeeze on living standards, which have not risen for the past thirty years or so.

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