Bust to Boom, and Back Again

Edward J. Dodson

[Reprinted from GroundSwell, March-June, 1990]


What is wrong in the Northeast?

The press has, in recent months, been filled with news stories and editorials asking that question. And with good reason. The vaunted Massachusetts economy, rebuilt on public/private partnerships and high technology industry, is in trouble. A close look at fundamentals shows why.

Remember when the Northeast was last in serious trouble? Middle and upper income households had abandoned the urban centers to the poor and fled to the suburbs. Heavy industry and other labor-intensive types of manufacturing closed down in the face of stiff competition from lower cost and higher quality producers (both domestic and foreign).

In a strange twist of fate, the energy crisis and changing demographics slowly brought higher income professionals back to the cities, and new defense contracts infused life into many high technology firms and university research facilities. While the federal government borrowed to pay the bills, the regional economy expanded.

Deregulation of the financial services industry added more fuel to the fire, as the Northeast's commercial and savings banks, as well as the savings and loan associations, provided the financing for new office towers, shopping malls, industrial facilities and new residential subdivisions and developments. The international situation, on the one hand extremely threatening because of the Josses experienced by major banks on loans in developing nations, also prevented the U.S. dollar from falling in the currency exchange markets; nearly all the debt owed by developing countries was denominated in our currency.

Despite a grossly unbalanced federal budget (Our national debt is some $3 trillion) and a continued trade imbalance, the international demand for dollars as the primary currency of trade and debt repayment has continued to protect us from our fiscal and monetary sins. For the service-based Northeast, its workers entered an era of steady employment and rising real incomes. Or, so it seemed.

What almost none of our political leaders or policy analysts seemed to understand was that an eventual downturn was inevitable, made so by counterproductive tax laws and other government regulations that penalized efficiency, productivity and financial success of all classes of businesses and worked in favor of those who engage not in production but speculation in land as their primary activity.

For a brief period, millions of house-holds and numerous investors would experience incredible gains in the one area of the economy to which hardly anyone gave more than passing notice -- the land market.

For four or five years the game was exciting. The acquisition of housing primarily for speculative gain and secondarily for shelter took off in 1985 in response to the return of single digit interest rates. Builders rushed to cash in on the renewed demand for housing units: and, those who had wisely land-banked developable sites captured tremendous profits as speculative fever took over in the housing market.

However, the biggest winners were the relatively small number of individuals and companies who controlled much of the land in the very hot Northeast markets.

The fundamentals of land markets may elude understanding by public officials, policy analysts and most economists; but, speculators have long recognized the tremendous advantages enjoyed by investment in land over-production of goods.

Land is different; for one thing, the supply of land in any given market area is relatively inelastic (or, virtually inelastic in the sense that the earth is finite). Prices but not the supply of the land will rise in response to greater demand; in fact, the supply nearly always declines as prices are rising because of speculation (i.e., the expectation that price will continue to increase at a rate considerably higher than that returned to the investor in alternative investment opportunities).

The speculative withholding of land from the market, in turn, places additional upward pressures on land prices. And, higher and higher land prices work their way throughout the economy -- making housing increasingly more expensive, driving up the cost of office and commercial leasing fees, driving up the cost of services, and everything that is produced and consumed.

This upward spiral continues until -- at some point -- businesses that must compete in markets with producers whose costs of production are considerably lower, are no longer able to do so. In many parts of the Northeast, businesses are unable to attract clerical or blue collar workers because these individuals cannot afford housing within a reasonable commute. Executives resist transfer to the Northeast because of the high cost/high tax environment. And, as is increasingly the case, the region's most highly trained and educated young people must take their skills elsewhere in order to find affordable housing.

Solving the problem of spiraling land prices by means other than a serious recession should be the number one priority for public officials in the Northeast. This can be done, and in. a relatively short time frame, if the state, county and municipal governments work together by using the tax system as a tool to not merely raise revenue but to stimulate the private sector to make the highest and best use of its landholdings and to reward productive activities.

The most direct step, and the one with the greatest promise for immediate results, is to replace or greatly reduce the state taxes on business and individual income or on sales with a surtax on assessed land values. At the same time, municipalities should be encouraged to gradually' eliminate that portion of the real estate property tax from falling on improvements and to collect the entire tax from assessed land values only. Assessments that are adjusted annually to as closely as possible reflect actual market value of landholdings make this effort all that much more effective.

What is different about land from production is the response of owners to taxation. Tax burdens on land increase the carrying cost to titleholders. Thus. an annual tax that roughly equals the annual rental value of a site in an environment of increasing land prices leaves the speculator with a very minimal net return on investment and virtually eliminates the propensity to hold land off the market. The aggregate result is an increase in the supply of land coming to the market, which would tend to drive down the price of land to developers, a savings that can be passed on throughout the chain of economic relationships.

Taxes on production, on the other hand, tend to make goods and services less affordable; or, if producers are unable to pass on the added cost of taxes, they may be forced to close down or relocate to what they see as a potentially more profitable location. The aggregate result is less economic activity, fewer employment opportunities, and a contracting tax base for government. All thanks to the conventional wisdom of existing tax policies.

Land prices are already falling in many parts of the Northeast, and with this fall we are seeing the failure of countless financial institutions whose loans to now-bankrupt real estate developers have defaulted.

The banks (and the regulators) now own large numbers of partially-completed and half-empty buildings. Had there been an appropriate mechanism in place to prevent the skyrocketing of land prices in the first place, real economic activity in production of goods and services would have driven the Northeast instead of speculation. An efficient tax structure that encourages production and penalizes land hoarding and speculation is that mechanism.

There is little time to lose if the Northeast is to avoid the consequences of a deep recession.