Sidetracked! Counting the Cost
of the Two-Rate Tax
Michael Hudson and Richard Noyes
[Reprinted from Land & Liberty, Spring
Dr Michael Hudson is a Wall Street analyst and
a co-author of A Philosophy for a Fair Society (London:
Shepheard-Walwyn, 1994). He is currently writing a history of
Richard Noyes is a Representative of the General Court of New
Hampshire (the state assembly), on whose Local and Regulated
Revenue Committee he serves as chief of local revenue.
TAX CUTS on income and capital can be financed either by cutting
public services, or by taking an increased share of land rents for the
public exchequer. The two-rate reform favoured by some Georgists is
not the solution, argue the authors, for the property tax accounts for
only 21% of state and local revenues. Instead of advocating taxation
on the full rental value of land, the two-rate taxers would leave
existing real-estate tax rates unchanged. So 79% of state and local
revenues and all federal taxation would remain as sales taxes and
income taxes, or other non-land levies.
Historian of 2Oth Century economic thought will be puzzled by the way
land speculation remained the major get-rich strategy even in
industrial and post-industrial economies.
A more modest irony also needs to be explained. There was a body of
theory (indeed, at one time a political movement) devoted to
collecting land values for the public. Why did the followers of Henry
George fail to bring to the public's attention the key role played by
land-value gains? Why has the annual value of land and other natural
monopolies not been authoritatively calculated, and why has the scale
of the "capital gains" from land and land-like natural
monopolies remained shrouded in mystery?
A related irony is this: why did the land-value tax movement use most
of its resources to advocate that real estate taxes be reduced, rather
than to raise the tax to capture the capital gains in land value? The
essence of what has become the "two-rate" tax movement is
not to raise overall real estate tax collections, but merely to
redistribute the existing tax to focus more on land. This change
is mainly only nominal. It will capture slightly more of the site
value of under-utilized lands. But it will still leave substantial
land-rent (and hence, land-value gains) in the hands of private
holders and speculators.
Rental income for the U.S. real estate industry is running at about
$800 billion per year -- about 14% of national income. At
least, this is what the National Income and Product Accounts (NIPA)
report for residential and commercial real estate. The figure does not
include mining or the oil and gas industries, fanning, forestry or
ranching, or the income generated by land-like monopolies such as the
electromagnetic broadcasting spectrum. Even for the real estate
sector, it misses the implicit rental value of much owner-occupied
land and underutilized sites. And it does not include revenue taken by
owners as capital gains, that is land-value gains.
The $800 billion figure only reflects residential property and
commercial real estate investment, after defraying all direct
operating expenses. From this, real estate owners pay over $300
billion to mortgage lenders as interest. This substantially
outstrips the $225 billion paid in local real estate taxes.
Virtually nothing is paid in federal income tax, largely because
landlords are able to set aside about $200 billion as a reserve for
the presumed decline in the value of their buildings as a result of
wear and tear. Also, as more and more revenue is paid out in interest
-- as landlords "pyramid" their equity by putting down as
little of their own money as they can -- this leaves less for the tax
While buildings and their fixtures wear out, land values rise over
time (despite some years of price corrections following real estate
bubbles). On balance, landlords come out ahead. They deduct from their
taxable income the interest they pay to mortgage lenders, as well as
the local property tax, and a fictitious amount representing the
pretended loss of the value of buildings.
Nothing is left for the federal government after the tax accountants
walk through the winding and rather tricky maze of loopholes, small
print and blatant giveaways that legislators have provided for the
real estate industry.
Increases in land value are not reported in the National Income and
Product Accounts, despite the fact that they represent a major part of
business enterprise's "total returns." Land values are
drastically underestimated by the Federal Reserve Board in its "Balance
Sheet of the U.S. Economy." Even so, these statistics show that
land values in the United States are now rising at about $1 trillion
This amount is commonly dismissed by national income economists on
the ground that it is not "earned" income. The national
income and product accounts focus on earned income (and interest and
Land is not a "product": no more of it is being produced.
What today's landlords and speculators obtain is not so much a flow of
revenue, but a capital gain. However, this capital gain is realized
only at the point where the land is sold, or where the property is
refinanced. Landlords may borrow the added land value from the banks,
simply by taking out a larger mortgage. Thus, because the land is not
"sold," the landlord gets his money from the bank without
having to pay tax on it! Indeed, refinancing the property often is
taken as an excuse for beginning to re-depreciate its buildings all
over again -that is, writing off their value as if the overall
property were falling rather than rising in price.
The important point is that capital gains from land substantially
outstrip the property's rental income (except, of course, when real
estate bubbles burst).
The existing real estate tax captures only a small fraction of
overall capital gains from land. This means that even if the two-rate
tax were levied entirely on the land, it would collect only about 28
to 30% of the rental value, and less than an eighth of the total
The two-rate tax leaves the great bulk of these capital gains in the
hands of speculators and other property owners -- unless the overall
tax rate is sharply increased. Real estate will continue to get
special tax treatment denied to industrial manufacturing, and to all
recipients of "earned income."
Lower taxes on capital gains than on "earned" income
(industrial profits and wages) induce investors to take their returns
in the form of speculation in real estate and the stock market (The
key to much of the stock market's gains represent the growth in
underlying land values, especially for newly privatized enterprises
which tend to underutilize their land value).
Special tax breaks for the real estate industry are often
rationalized on the ground that they are necessary to spur
construction. This approach would reclassify what Georgists (and
indeed, classical economists) call "rent" and turn it into "profit,"
that is, what Frank Knight called "compensation for risk."
By the early 1990s the real estate industry's gross rent was about
$700 billion annually. But only 0.3 percent of this was paid as income
taxes. The industry avoided income taxation by using many loopholes,
most of all by over-depreciating buildings even as rising land prices
more than made up for the wear and tear. The upshot was that rental
income appeared as a "capital gain" rather than income --
and low capital-gains rates provided an incentive to hoard, rather
than to build and actually earn income.
To the real estate industry, mortgage interest now represents the
most important cost. Most of the rental value of US land has been
pledged to mortgage lenders as interest to carry the property. This
creates a political problem. Collecting more of the land's rental
value for the public would be at the expense not simply of the
landlords holding title to this land, but at the expense of the
bankers behind them. Landlords could rightly claim that they are being
"squeezed," because the gamble they took -- that they could
hold out by always using the land's rental value to pay interest to
their bankers in their belief that land prices would rise indefinitely
-- did not provide them with the pot of gold they had anticipated.
Examine the chart [not reproduced here but provided in the
original paper] (from a study by Michael Hudson and Kris Feder,
published for the Levy Institute at Bard College on "Real
Estate's Role in the Capital Gains Debate"). The mortgage figures
show that even a half-point increase in the mortgage rate is more
important, quantitatively, than a total shift of the real estate tax
from buildings to land. For the local real estate tax itself is only
1% or 2% -- nowhere near as high as interest rates. Shifting this
marginal tax from buildings to land thus is an insignificant shift. It
gets easily lost in the wash of overall mortgage debt and depreciation
The important point is that a switch to two-rate taxation would not
add significantly to the revenue of owners of buildings, except to the
fraction of a percentage point of the property's value representing
that portion of community-wide taxes that can be shifted to
underutilized land such as parking lots or vacant lots. The tax
obligations of statistically "normal" real estate would be
unaffected. All that occurs is a reclassification of the nominal tax
from one category to another. Heavily built-up sites would benefit
slightly, but as long as the total real estate tax rate is only a few
percentage points of the property's actual value -- and most land is
not underutilized -- the effect is more symbolic than real. The
two-rate tax certainly does not capture anywhere near the land's full
rental value, and hence the gains in land-value.
The major objectives of real estate investors are to secure capital
(that is, site-value) gains; to minimize (and defer) taxes on this
gain; and to cover the holding cost (or hoarding charge) by borrowing
from banks, S&Ls, insurance companies, pension funds or other
lenders. So little of the land's rising value has been collected by
government that mortgage interest is now of much greater concern to
the real estate industry than are property taxes. (Meanwhile, the
income tax barely touches real estate at all!)
Real estate developers typically are willing to turn over all their
net operating income to the banks as mortgage interest, in the hope of
"cashing out" at the end and selling their property for a
mark-up -- not a "profit" as such, but a return in the form
of the more lowly-taxed capital gain.
These gains are almost entirely land- value gains, as buildings
themselves do indeed depreciate. Rising land values are so large that
their recipients have been able to gain control of the political
process to shift federal taxes onto labour and industry, via sales
taxes and income taxes on wages and other earned income. In effect,
government is manipulating the tax system to subsidize unearned
The effect is to warp the economy. What has been welcomed as "post-industrial"
growth turns out to be merely a gentrification process. The major way
to get rich today remains the same as it was in industrial and
pre-industrial economies: to reap land-value gains. Yet Georgist
institutions have not made this seeming anomaly an issue of national
debate. Indeed, no one seems to know about it, except landlords and
The public is left to imagine that stock-market gains reflect the
financing of new industrial investment (initial public offerings, or
IPOs), whereas in fact they reflect the recycling of land rent into
new real estate lending, which puffs up land prices. Until the public
recognizes how savings are recycled to inflate the land bubble, little
will be done to close the loopholes that divert income away from
industrial investment to real estate speculation.
Only when people realize that industrial investment and consumption
are being taxed (or public services cut back) mainly to free more
income for land speculators will the anti-tax movement achieve a
The two-rate tax movement had some logic early in the century, when
real estate taxes made up the bulk of state and local budgets. But
today, property taxes make up only about 21%. Thus, the allocation of
this tax as between land and buildings is nowhere near as important as
it once was. This is especially important in states such as
Pennsylvania, where real estate is taxed at slightly over 1 percent of
the property's assessed value. Today's two-rate tax movement aims at
shifting the existing real estate tax from buildings and other capital
improvements to the land. This is to be done without raising the
overall level of revenue. "At the margin" it raises taxes
for land without buildings: parking lots, used-car dealerships, and
other underbuilt property. And by the same token, it would lower taxes
on the community's largest buildings, electric power utilities and
other expensive structures.
Advocates of the two4ate tax system want to promise that property
taxes for most residents will decline. But if the existing real estate
tax captures only a portion of the land's rental and sales value, this
means that the two4ate tax will still leave a major part of total
returns" in the hands of private holders.
This is a far cry from what Henry George advocated. Indeed, the
two-raters have sought to win votes for their program by trying to
find communities where they can appeal to most property holders that
their real estate taxes will be reduced. This can occur only
in communities that have substantial underdeveloped land, with no
major buildings -- in other words, rather poor communities.
To be sure, this reduction in most peoples' property tax rates
probably was not how the two-tax movement began. No doubt its early
proponents were searching for some kind of "real world"
victory, some way of putting before the public -- and enacting into
law -- the economic distinction between land and capital improvements.
But in attempting to attract voters, appeals were made to their narrow
self-interest: their own property taxes could be reduced by shifting
the burden marginally onto underutilized land (as long as an even
higher tax yield of large commercial buildings would be shifted onto
residential homeowners, that is!)
The basic theme of Georgism is society-wide economic interest. This
theme is lost in the two-rate campaigns. Even worse, two-raters have
sought to direct as much of the movement's resources as possible into
their campaign, leaving advocates of the larger economic picture out
in the cold. Academic efforts and serious research efforts have even
been discouraged on the ground that they distract attention from their
own local efforts.
If communities have some major, highly expensive structures -- a
public utility, or a few very large buildings -- shifting the existing
property tax onto the land will free these large capital developments
from taxation, and distribute former tax levy among the remaining
landholders. Obviously, this is not a vote-catching idea.
Why are voters (and for that matter, most Georgists, as the Plotch
Report [Open Forum, Land & Liberty, Winter 1996] has
shown) so cool to the two-rate tax? The answer is simple: there is
little to get excited about. It is a very marginal tax, symbolic
almost only to Georgists. Most people have grown tired of voting for
Indeed, the two-rate tax shift is so marginal that the voters of
Amsterdam elected to return to the prior system. Voters in Harrisburg,
Pennsylvania -- one of the first cities to try out the two-rate system
-- likewise are now swinging against the two-rate system. As used car
dealers found the tax bills on their unbuilt lots rising, they
combined with parking lot owners and real estate hoarders who had
built "taxpayers" (that is, one-story structures rented out
at a nominal fee to cover their local tax costs and mortgage payments
to their bankers), while waiting for land prices to escalate.
If the two-raters have been unable to convince voters of the justice
of taxing unearned income in the face of such seemingly obvious
special-interest pleading, is it not time to renew the discussion at
the national level? And while doing so, isn't it time to begin a
serious annual report on the real estate industry's special loopholes,
and how these loopholes are becoming increasingly parasitic in
character? Such quantification would enable the cost of the real
estate industry's special pleading to be measured, and land-value
returns could be compared to industrial and commercial profitability.
Would not voters be more excited to be shown the extent to which the
U.S. economy -- an economy which most people imagine to be powered
mainly by industrial innovation -- is really a rentier economy
based on gentrification to inflate the real-estate bubble and the
privatization of hitherto public natural monopolies?
With all the news about buying political influence, is there not good
publicity to be made of the fact that the largest political
contributors at the federal, state and local level are real estate
developers? Their payoffs are made in local property-tax variances and
public subsidies for favoured contributors, and nationally in the form
of the loopholes that have virtually freed the real estate industry
from income tax liability. Property taxes also are being reduced
relative to other taxes.
In one state after another, legislatures have limited the property
tax to represent less and less of state and local revenues. In 1978,
California passed the infamous Proposition 13, limiting to 2% the rate
at which property taxes could be raised each year. The upshot was that
while land values doubled and redoubled in the 1980s, property taxes
did not keep pace.
Iowa limited its annual property tax increase to 4% in 1979, while
Arizona imposed a 10% limit. In 1981, NewYork City limited the
property tax increase on residential apartments to 8% (30% in five
years), while a 6% limit (or 20% in five years) was imposed on
residential property taxes in the city and neighbouring Nassau County.
Land values soared so far ahead of tax rates that a real estate bubble
ensued during 1985-91.
Other states are jumping on the bandwagon to replace property taxes
with sales and payroll taxes. In 1994, Florida limited the annual
increase in residential homestead property taxes to 3%. Michigan chose
the lower rate of either 3% or the consumer price index percentage
increase. In 1996, Oregon limited the tax increase on individual
property to 2%, while Oklahoma limited the annual rise in the real
property taxes to 5%.
Without reducing the nominal tax rate, states have thus found ways to
limit the increase in real estate taxes. Under these conditions,
shifting the property tax from buildings to land would capture a
shrinking part of the land value gains. The speculators, greed-mongers
and the politicians representing their interests are way ahead of
Georgists in finding ways to shift these local taxes from their land
onto labour and capital.
The counter-strategy would be to inform voters of how the economy is
warped by taxes on new direct investment and employment, while land
speculation is encouraged. At the end of this path, businessmen will
make their money off the land bubble rather than from entrepreneurial
To focus attention on battles fought in the past, voters (and many
Georgists themselves) lose sight of the big picture. Georgism becomes
marginalized: the two-raters are arguing about a real estate tax that
The irony is that property owners accept jumps in mortgage interest
rates as long as their land values and rents are being inflated at an
even higher rate. To increase their returns (they cannot do much about
the mortgage rate) speculators have mobilized homeowners to fight
against the much less burdensome increases in property tax rates.
In the end, peoples' behaviour reflects their overall world-view. The
contribution of Henry George was to demonstrate the dominant
importance of land in the broad economic picture. Voters and lawmakers
became vigilant. Reawakening today's voters to land's importance
requires the presentation of statistics at national and local levels.
Armed with such a data bank, calculations would show the real-world
consequences of deciding what kinds of economic activity to tax:
active investment gains by capital, labour and its living standards,
or the passive unearned increment" of land appreciation.
Such an educational initiative costs money. By having lost the
public's attention (not to speak of land's shrinking role in academic
economics), Georgism has allowed its intellectual capital to become
depleted in recent decades even as the endowments of some Georgist
institutions have grown!
Rather than fighting yesterday's two-rate battle, we need to invest
to help people put their economic frustrations in the context of an
overall economic philosophy. The property tax has become America's
least popular tax. It represents a shrinking proportion of personal
income -- just 3.5 percent today, down from 3.8 percent in 1992, and
4.3 percent in 1978. It seems that voters would rather tax labour and
capital than land!
Only an overall philosophy will enable people to make sense of the
chaos in the economy. Once people gain this broader sense of
proportion, their fiscal perspective will follow. A logical first step
would be to prepare an annual chartbook and economic atlas. This would
illustrate a body of theory that may excite people today as much as
Progress and Poverty excited them a century ago and explain
why our epoch has failed to provide prosperity for many outside the
upper rentier layer.