How the Tax System Creates Depressions Like the Crash of 2008

Fred E. Foldvary

Dept. of Economics, Santa Clara University

Joseph Schumpeter identified the mostimportant turn in the cycle as the points of inflection.

The upward swing switches from acceleration to deceleration.

The peak of net investment is reached at the point of inflection.

The elements of the cycleDepression: the trough

The monetary-interest element

The Austrian-school business cycle:

if interest rates are artificially lowered due to an increase in the money supply by a monetary authority,

this induces an increased investment in higher-order capital goods unwarranted by free-market demand.

Real estate the major player

• Real-estate construction is a major portion of higher-order capital goods.

• Artificially low interest rates induce a construction boom.

• Land values rise beyond the point at which enterprises can make a profit after paying for rent or mortgages.

House Price Appreciation Source: Office of Federal Housing Enterprise Oversight

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1990 - Q1 1995 - Q1 2000 - Q1 2005 - Q1

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Land value rise in NY

New York Real Estate Price Indices

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q1-1999 q1-2000 q1-2001 q1-2002 q1-2003 q1-2004 q1-2005 q1-2006

Land

OFHEO

The US real estate cycle

land value construction depression• interval interval

interval• 1818 -- -- -- 1819 --• 1836 18 1836 -- 1837 18• 1854 18 1856 20 1857 20• 1872 18 1871 15 1873 16• 1890 18 1892 21 1893 20• 1907 17 1909 17 1918 25• 1925 18 1925 16 1929 11• 1973 48 1972 47 1973 44• 1979 6 1978 6 1980 7• 1989 10 1986 8 1990 10• 2005 16 2005 19 2008! 18!

Government land subsidies

• Tax deductions for interest and property taxes.

• Capital gains tax exemptions.

• Tax-free real estate exchanges.

• Repeated legal-fiction depreciation

Public Works: the Mother of all Interventions

• Much of the value of land comes from public works and services, paid for by taxes on labor and capital goods.

• Adam Smith noted that "Every improvement in the circumstances of society tends either directly or indirectly to raise the real rent of land,

to increase the wealth of the landlord."

Public works and civic services increase the value of land.

Little of this is paid from property taxes specifically on land.

So these public goods get capitalized as higher land value and more rent.

High interest rates

and high prices

for real estate

choke off new investment

Result: the financial waterfall

The fiscal and monetary remedy for depressions

• The elimination of the business cycle implies the elimination of the real estate cycle.

• This can be accomplished by the collection of ground rent either by private communities or

by government, eliminating the implicit subsidy to landowners.

• We also have to eliminate the financial side.• The remedy for credit manipulation is free-

market money and banking with competitive private bank notes.

Public Goods are effectively provided by private enterprise by tapping the generated site rent.

Fred Foldvary, 1994

Public Goods and Private Communities• Market success providing public

goods, in theory and in practice.• Demand is revealed by rent.• No free riders: users pay rent.• Land trusts, condominiums,

residential associations.

Taxing Rent or Land Value

* The land-value tax applies to either the implicit rental value of land or on the potential site value, exclusive of the value of improvements.

* LVT would apply to all owners of land, including household, commercial, and government-owned real estate. Taxing government land adds pressure to manage, maintain, and retain an efficient amount of public land.

* Land values would be assessed as they are presently for property taxes, distinguishing between site and improvement value.

Tax Reform Options (adapted from Tony Quain, student of Dan Klein)

• Ideology: Progressives;• Environmentalists (LVT

efficient and equitable)• Geo-libertarians

(libertarians who reject homesteading)

• Conservatives: Buckley

Implemented:• Estonia• Taiwan• Singapore• Hong Kong• Sydney,

Australia• Arden, DE

Endorsements• Adam Smith• John Stuart Mill• Milton Friedman• Thomas Paine• William F.

Buckley, Jr.• Albert Jay Nock• Sun Yat Sen• Winston

Churchill• Frank Chodorov• Henry George• Harry Gunnison

Brown

• Origins: Analyzed by American political economist Henry George in 1879 (but the 1700s Physiocrats had the idea of only taxing land.)

Public Finance & the Cycle

• The 18-year real estate cycle in the US and in other countries gives the enhanced Austrian cycle theory predictive power.

• The 2008 bust came 18 years after the 1990 downturn, right on schedule.

• The focus on real estate provides a more thorough and predictive explanation of booms and busts, and the remedies:

• Private communities or Land Value Tax.