Why "Housing" Costs Climb and Climb ... Then Periodically Crash

Edward J. Dodson

[A letter to The Independent in the United Kingdom, 17 March, 2007]

Dr. Eamonn Butler of the Adam Smith Institute commented yesterday that the housing market “is not in fact a free market.” This is certainly the case but requires further explanation than he provided in his letter.

More importantly, some involvement of public agencies is required to establish the basis for competitive market conditions to operate. This is a point Adam Smith made – and one too often ignored by modern exponents of Smith’s doctrine -- in his great work on political economy.

Housing affordability is determined by several important variables: housing prices (which in turn are composed of land costs and materials costs), mortgage interest rates and terms, household incomes, available savings, and access to grants and other subsidies (e.g., abatement of annual property taxes).

How government raises its revenue is also of fundamental importance, as Adam Smith well understood. Taxes on the capital value of houses (and, on all buildings) are a burden that makes housing more expensive to construct and own. From the perspective of economic efficiency, the ideal rate of taxation on housing is zero. However, merely exempting housing from taxation would solve neither the problem of supply nor of affordability.

Exempting housing units from taxation must be accompanied by the full taxation of land values. In Adam Smith’s time, the discussion over whether to tax land values focused almost entirely on agricultural land, ignoring land used for residential or business purposes. That being said, the principles involved are identical. Every parcel of land – every location -- has some annual rental value as determined under competitive market conditions. This “rent” where residential property is concerned is created by aggregate public and private investment -– in roads, other public transit, hospitals, schools, water and sewer systems, libraries, and other amenities that make a community an attractive place to live. For nearly two centuries, political economists argued back and forth over whether the rental value of locations ought to be publicly collected.

Despite an indisputable analytical case in favor of doing so, powerful landed interests (combined in more recent times with powerful bureaucratic interests of those livelihoods depend on endless government subsidy programs) has succeeded in preventing this common sense measure from being implemented as universal public policy. The result is that our so-called market economies are plagued by dysfunctional land markets.

When the demand for labor, for capital goods and for credit are increasing, the supply of these economic factors brought to the market increase. The market reaches a competitive equilibrium (i.e., a place where supply and demand meet to satisfy the interests of everyone involved). This does not occur with respect to land markets today because the effective rate of taxation on “rent” is so low. Rising demand for land does not bring land owners to the market offering their land to developers. Speculators compete with one another to acquire locations to be held for some period of time (depending on their own financial resources) in anticipation of future gain in price. Long-term owners of land feel no financial pressure to bring the land they hold to market.

Rising demand for land pushes land prices upward to the point where nothing can be constructed without huge government subsidy. And, since government finds it increasingly difficult to impose taxes on the landed and others at the top of the income scale, the only recourse is for government to borrow from those it is unwilling to tax.

Under current conditions, those who desire to construct new housing units or other buildings are forced to negotiate with these speculators and with landowners whose annual carrying costs of the land they hold are often nominal. Public assessment of real estate for tax purposes is generally terrible, and vacant land is rarely reassessed to reflect current market values. Such assessment practices exacerbate the problem to the advantage of land speculators and the landed generally.

In summary, whether one is living in the U.K., the U.S. or elsewhere, the primary cause of the lack of decent, affordable housing is flawed public policy. The income derived from landownership is unearned; landownership is a static activity that produces no goods or services. Exempt housing from taxation and more to publicly collect the rental values of locations and the market will do the rest.