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Foundational Principles and Derivatives

CS Clay Shentrup Public Seen by 363

We set out with some basic principles on what to tax or subsidize. https://medium.com/@ClayShentrup/what-to-tax-or-subsidize-42cd7dc5c726

CS

Clay Shentrup Sun 22 Oct 2017 10:54PM

One question that I've been mulling over since posting this is the issue of deadweight loss. A simple example is that I have a product over which I have a monopoly, allowing me to cheaply create a widget that can massively improve human welfare. I could sell it cheaply enough for a million people to buy it and benefit from it, or I could set the price so high that only a few rich people can afford it. But in the latter case, they'll pay so much money that I'd be better off. But this causes a net welfare loss.

Mulling over this, it feels like it actually behaves like a positive externality. That is, if we were to subsidize the widget producer to make it slightly more profitable to sell to the masses, then we'd increase net utility. The issue then is simply whether that money could be more effectively spent on some other positive externality, or by direct transfer to people.

This came up in discussions with advocates of Land Value Tax, one of whom argued it effectively addressed deadweight loss caused by certain individuals essentially having monopoly rights over land.

Example argument:

Demand curve is currently moved to the right compared to a perfect market (where everybody rents their immovable property thus paying twice as much for their housing expenses) causing a deadweight loss. Evidence. We see excessive vacancy, under occupation

He seems to be saying that landowners will essentially horde land, because e.g. it would be better to sell one parcel of land for a million dollars than two lower the price and sell two parcels of land for 499,000. This seems a flawed argument to me but I'm still thinking on it.

FS

Felix Sargent Mon 23 Oct 2017 10:11PM

Not sure exactly what the question is - would you like a discussion on how tax affects monopolies, or one specifically focused on Land Value Taxes?

I think this thread explains it best. I could summarize it - but it speaks for itself.
https://www.quora.com/How-does-a-land-value-tax-not-create-deadweight-losses

There's actually no deadweight loss in a monopoly market in the short term. Everything that can be supplied is supplied, whether you tax it or not. Just because I'm getting taxed 10% of my rent doesn't mean I'm going to supply my apartment any less. It's because of this lack of dead weight loss that LVTers say that it's the perfect tax. You can tax land owners to 90% and as long as they're still making their nominal profit they're going to supply the land to the market.

CS

Clay Shentrup Tue 24 Oct 2017 6:26AM

The author of that Quora response is the same person I'm responding to here. I wasn't talking about whether LVT creates deadweight loss, but whether it fixes some existing deadweight loss, which is what he seemed to be arguing elsewhere.

A simple thought experiment: suppose you have a tax of 100% of the market value of a parcel of land. Now just call that a "rent", because it is. Now realize that a rent is equivalent to a one-time payment of its net present value, so the government should be equally willing to sell land outright instead of the 100% rent/LVT. Especially given people want to be able to build immovable property on top of it.

Government definitely shouldn't institute a rent/LVT on land that was already purchased. When an LVT is instituted, it only harms the poor individual who randomly happens to be holding that "hot potato" at that point in time, by reducing the value of the land by the NPV of that LVT stream. If he sells it, the original owner has to discount the price by that amount. So it feels like a one-time tax on the current owner, which isn't justified by anything. It can't be, because it has nothing to do with his wealth.

He said:

only the individual or firm able to put it to it’s most productive use will pay the most to exclude others from an irreproducible factor of production.

This makes no sense. The current owner already has an incentive to make the maximum profit from the land. Adding a tax to it doesn't change that, aside from making him poorer and thus increasing the marginal utility of his dollars which may incentivize him to work more.

Also it doesn't matter that land is irreproducible. All resources are finite, including human labor. (And actually, you CAN make more land. See Holland and San Francisco.)

FS

Felix Sargent Tue 24 Oct 2017 3:22PM

I'm still not sure what exactly you're arguing for here.

To level set: There is no deadweight loss in the existing land owning market as the supply curve is very close to straight up and down. Normal theory on Dead Weight Loss says that when you introduce a tax (say 10%) on a normal good, such as soda ($100M market), the consumer will consume less, and the supplier will supply less. You might think that a 10% tax on a $100M market would lead to $10M. But the tax will end up shrinking the market to $70M, and the tax will be less effective than expected $7M. The dead weight loss here is $30M which simply vanishes into 'inefficiency'.

The reason that LVT is a good tax is that the supply of land is very nearly always fixed. Suppliers/Landlords have no marginal costs that they would save by holding back their land when they are taxed - they just have to eat the tax (and still earn a nominal profit).
It doesn't fix deadweight loss because deadweight loss isn't a factor in the market.

LVT isn't a good tax because it fixes a negative externality or corrects a market. LVT is a good tax because it can't distort the market. In an ideal world, we'd put in place taxes to correct for market failures such as congestion and pollution taxes first - but when the market obeys those incentives and reduces pollution tax revenues will fall.

LVT taxes make a great backstop because the taxes can't be avoided, and will consistently generate revenue so the government can provide services.

CS

Clay Shentrup Tue 24 Oct 2017 5:01PM

I'm still not sure what exactly you're arguing for here.

Foundational principles on "what to tax or subsidize", as well as the particular use of these principles to show that the arguments for LVT are incoherent.

But the tax will end up shrinking the market to $70M, and the tax will be less effective than expected $7M. The dead weight loss here is $30M which simply vanishes into 'inefficiency'.

The only reason to tax a thing/activity is if it's a negative externality in the first place, in which case there's absolutely no dead weight loss. The opposite. You tax soda if you think it produces a negative externality, in order to avoid dead weight loss.

The idea of a Land Value Tax doesn't make sense as a tax. If you think about a carbon tax by contrast, it's there to shape incentives, to encourage people not to produce carbon emissions. But if the amount of land really is fixed, then there's nothing to disincentivize by taxing it. Actually, technically, you can produce more land by "terraforming"—so LVT actually would disincentivize doing that, as if it's a negative externality. Which... it's not, in any clear sense. (Yeah, there are complex environmental impacts but that's different.) So it just makes no sense as a tax.

The deadweight loss argument is saying that the point of LVT is for government to make money, in a way which seems to have minimal downside. But actually, that inability to shape incentives is precisely why LVT is irrational. It effectively is just a tax on the owner. But when you tax people (rather than things/activities) that should be based purely on their wealth. Richer people have a lower marginal utility per dollar. But that's entirely orthogonal to land ownership. So LVT makes no sense.

FS

Felix Sargent Tue 24 Oct 2017 5:48PM

You're confusing the economic reality of supply and demand curves with morality. Let's ignore if a tax is just or not, and let's just look at how a tax effects the price, supply, and demand.

A deadweight loss is defined as "a loss of economic efficiency that can occur when equilibrium for a good or a service is not achieved."

This could be in the trade of harmful drugs or in helpful medicine. There isn't a moral connotation to deadweight loss. Take for example a price floor on medicine. https://en.wikipedia.org/wiki/Deadweight_loss#/media/File:Deadweight-loss-price-ceiling.svg The government will intercede to lower prices, and producers will be affected by that. Producers will be less likely to supply into that market, leading to scarcity. That scarcity is measured as "dead weight loss."

Now let's look into the other issue you're discussing, which is Pigouvian taxation. You establish a few criteria about "sensible taxes" but you ignore the #1 reason for taxes: to fund the government. Any benefit besides funding the government is auxiliary in the current mindset. You're right - Pigovuian taxes are better for society and should be the primary form of taxation.
But let's say that you put in place all the Pigouvian taxes you can. But it's not enough! The carbon taxes brought carbon emission rates down. Everything is running on green energy, so nobody has to pay the carbon tax. Congestion charges make transit flow effectively, and most people take transit, dodging the tax.
But now the government has no money to pay for the services that don't pay for themselves. Where does it raise money from?
Now you need to setup arbitrary taxes. Which arbitrary tax is the least bad?

CS

Clay Shentrup Tue 24 Oct 2017 6:08PM

Let's ignore if a tax is just or not, and let's just look at how a tax effects the price, supply, and demand.

Whether it's "just" (maximizes utility) is precisely the thing at issue here.

There isn't a moral connotation to deadweight loss.

It's a moral issue in that it affects welfare. You want to maximize net wealth to maximize net utility.

you ignore the #1 reason for taxes: to fund the government

No. Funds to the government meet the same criteria as taxes. They are useful to either directly give to individuals to improve their welfare, or to address positive externalities. If you run out of externalities to tax, but you have an opportunity to improve welfare, you can then start taxing wealth (people, not activities) to spend on that welfare improvement subsidy. But it's virtually inconceivable for it to make sense to tax activities that aren't externalities.

And my other point was that LVT effectively is a tax on people, not activities. So you should just tax the richest people, not people who happen to own land.

FS

Felix Sargent Tue 24 Oct 2017 7:07PM

Deadweight loss is an economic definition. I agree with you that it's better for markets to be efficient - and therefore deadweight loss should be avoided. LVT is a tax which does not cause deadweight loss. Because of this efficiency, it is the least distorting tax. As you were saying it's a moral issue to maximize net wealth to maximize net utility. Because LVT maximizes net wealth by not causing deadweight loss, it also maximizes net utility.

How else would you tax the richest people, in a nondistorting fashion?

CS

Clay Shentrup Tue 24 Oct 2017 7:46PM

LVT is a tax which does not cause deadweight loss. Because of this efficiency, it is the least distorting tax.

But it's effectively just a tax on a person rather than on an activity. It's like saying, "We need to raise 1000$, let's have a lottery and tax some random person 1000$." You'll be better off taxing the richest people, rather than random people who happen to own land.

FS

Felix Sargent Tue 24 Oct 2017 8:49PM

It's a tax on people who invested in real estate. The activity is "land ownership." Not all people own land.
1. All economic activity is ultimately derived from land, so if you tax land, you tax all economic activity on an even basis.
2. Land owners are monopoly rentiers - their wealth earned from investment in land is not in proportion to the risk that they would take as if they were loaning their money to the capital markets. Because of this, it is far more ethical to tax them then a capital gains tax or an income tax.
3. A random lottery tax has no progressive nature. Land taxes tax wealth. A tax on wealth is inherently progressive and better for society. If they don't want to get taxed, they should sell their land.

CS

Clay Shentrup Wed 25 Oct 2017 4:43AM

The activity is "land ownership." Not all people own land.

But there's no reason to tax people who happened to own land. You want to tax people based on their wealth, not the particular asset they've traded their dollars for. Simple thought experiment: Bob sells land to Alice. If the LVT goes into effect before the sale, Bob is taxed. If it goes into effect after the sale, Alice is taxed. Completely and totally arbitrary.

All economic activity is ultimately derived from land, so if you tax land, you tax all economic activity on an even basis.

A. You don't want to tax all economic activity. You want to tax externalities and wealth.
B. Economic activity is as derived from all sorts of matter, not just dirt. Air drives combustion engines and water drives steam, etc. Plus there's lots of stuff that we've pulled out of the "land", like precious metals, lithium, etc. It' not even clear what the exact definition of "land" is.

Land owners are monopoly rentiers - their wealth earned from investment in land is not in proportion to the risk that they would take as if they were loaning their money to the capital markets. Because of this, it is far more ethical to tax them then a capital gains tax or an income tax.

This makes no sense, because the prices of various assets from land to Google stocks already reflect risk. People routinely choose to invest in stocks, Bitcoin, etc. over land assets like REITs. James Altucher even points out:

“But its an investment,” you might say to me. Historically this isn’t true. Housing returned 0.4% per year from from 1890 to 2004.

Land taxes tax wealth

No. You could have 10 times my wealth but have it invested in stocks instead of land, and LVT affects me more. AND it doesn't even affect people equally over time. It only impacts the people who happen to be stuck holding the land at the time the LVT goes into effect.

FS

Felix Sargent Wed 25 Oct 2017 2:47PM

Bob is taxed. If it goes into effect after the sale, Alice is taxed. Completely and totally arbitrary.

Any tax is arbitrary. Why do you think a "Good tax" must be applied to every person? Poll taxes are a notoriously bad and unpopular thing.
On the other hand, because land+labor*capital is the source of all goods, any tax on land will tax the entire economy evenly.
Let's not argue implementation details but instead discuss what an ideal system of taxation should be.

You want to tax externalities and wealth.

What's your definition of wealth? I feel like I'm just quoting "Progress and Poverty"
Wealth is stored wages. Wealth is made from either Rent, Wages, or Interest. If you tax interest, investment decreases. If you tax wages, production decreases. If you tax Rent, nothing bad happens.
We don't have to invent a new definition of Land. The existing one works just fine. There are surface, air, and mineral rights - but the money you charge from the use of your land is called Rent.

Citation needed on James Altucher. https://howmuch.net/articles/this-animated-map-shows-the-rising-cost-of-land-past-forty-years-gif4

I can't recommend reading Progress and Poverty enough. He explains the arguments far better from both an economic and moral perspective than I am able to explain by rebutting your arguments.

  We may as well cite historical illustrations of the attraction
  of gravity; the principle is just as universal and just as obvious. 
  Rent must reduce wages. This is as clear as an equation: the larger the subtractor, the smaller the remainder.
  The truth is self-evident. Put this question to anyone
  capable of consecutive thought:

  “Suppose some land should arise from the English
  Channel. This land will remain unappropriated—like the
  commons that once comprised a part of England. An
  unlimited number of workers can have free access to it.
  Here, a common laborer could make ten shillings a day.
  What would be the effect upon wages in England?”

  They would at once tell you that common wages
  throughout England must soon rise to ten shillings a day.
  Ask, “What would be the effect on rents?”

  After a moment’s reflection, they would tell you, “Rents
  must fall.”

  If they thought out the next step, they would tell you
  that all this would happen without much labor being diverted
  to the new natural opportunities. Nor would the
  forms and direction of industry change much. The only
  loss would be the kind of production that now yields, to
  labor and landlord together, less than labor could secure
  on the new opportunities.

  The great rise in wages would be at the expense of rent.

  Next take some hardheaded business owners who have
  no theories, but know how to make money. Say to them:

  “Here is a little village. In ten years, it will be a great city.
  The railroad and the electric light are coming; it will soon
  abound with all the machinery and improvements that
  enormously multiply the effective power of labor.”

  Now ask: “Will interest be any higher?”

  “No!”

  “Will the wages of common labor be any higher?”

  “No,” they will tell you. “On the contrary, chances are
  they will be lower. It will not be easier for a mere laborer
  to make an independent living; chances are it will be
  harder.”

  “What, then, will be higher?” you ask.

  “Rent, and the value of land!”

  “Then what should I do?” you beg.

  “Get yourself a piece of ground, and hold on to it.”
  If you take their advice under these circumstances, you
  need do nothing more. You may sit down and smoke your
  pipe; you may lie around like an idler; you may go up in a
  balloon, or down a hole in the ground. Yet without doing
  one stroke of work, without adding one iota to the wealth
  of the community—in ten years you will be rich!
  In the new city you may have a luxurious mansion.
  But among its public buildings, will be an almshouse.
  In all our long investigation, we have been advancing
  to this simple truth:

  *Land is required for the exertion of labor in the production
  of wealth. Therefore, to control the land is to command all
  the fruits of labor, except only enough to enable labor to continue
  to exist.*

http://www.henrygeorge.org/pdfs/PandP_Drake.pdf

I came to this argument after buying my first home and renting it out. My renter pays my mortgage, HOA fees, and a small profit on the side. I couldn't believe my luck. My wealth is increasing year by year and I'm doing little if any work. Not only is it generating income, and paying my loan, but the home itself is appreciating in value. No other economic activity behaves like this. It's not normal. It's not the same as owning a stock.

Agree or disagree -- what's your alternative? You pick a form of taxation that we should use to tax the rich, and then let's compare.

CS

Clay Shentrup Wed 25 Oct 2017 3:25PM

Any tax is arbitrary.
No. Ideally we're choosing them to optimize human welfare.

Why do you think a "Good tax" must be applied to every person?
To optimize human welfare.

because land+labor*capital is the source of all goods, any tax on land will tax the entire economy evenly.
I don't know what this is supposed to mean. A tax on land certainly does not tax all people evenly.
It just takes money away from the person who happens to be holding it when the LVT goes into effect. And if land is the source of all goods, then that will be factored into its price. And again, there's nothing special about land here. Minerals that have been pulled out of the ground are assets that drive the economy too.

What's your definition of wealth?
We can just say "money" or "things that can be converted to money" to avoid semantic digressions. You may have heard the term "net worth".

If you tax interest, investment decreases. If you tax wages, production decreases. If you tax Rent, nothing bad happens.

Taxing wealth doesn't tax any specific source of wealth. So it just decreases the incentive to get wealthier in general. You obviously have to be careful here and only tax to the point where the benefit you can cause with the wealth transfer outweighs the harm to production. But with LVT you're just taxing random people who happened to own land. It's no different than if you looked up people in the phone book and rolled dice to decide who to tax. This is much less efficient because those people may be nowhere near the richest, and thus your tax causes more harm to them than if it had been applied to rich people.

And if you think taxing a random person (e.g. LVT) has the benefit of not distorting incentives, you're wrong. Because a random tax feels identical to a universal tax of an expected percentage of your wealth. E.g. if you tax 10% of people 100% of their wealth, it feels like taxing 100% by some percentage of their wealth (I forget the logarithmic math to get that percentage atm).

My wealth is increasing year by year and I'm doing little if any work.

Sigh. Are you arguing that 100,000$ worth of land is worth more than 100,000$ worth of gold or Google stock? Do you see how this doesn't make sense? This is enumeration of favorable circumstances. You're ignoring all the people who lost money on rent. And even if land owners made more money, so what?! Just tax the richest people regardless of how they made it.

It's not the same as owning a stock.

It is exactly the same.

You pick a form of taxation that we should use to tax the rich

What do you mean "form" of taxation? You just tax them.

And to repeat another thing that I keep trying to hammer on, an LVT only affects the people who owned the land at the time the LVT went into effect. That's it. Then it's over. They'll have to discount the land when they sell it, by the NPV of the LVT. So a future Rich Guy owner who buys it next is totally unaffected by the LVT.

As an analogy. Suppose I'm renting a car space. Every day I pay 10$ for it. Then one day the government decides to double the price. I can leave if I think that's too high. Easy as pie.

But suppose instead that I BUY the parking space from the government, for 10,000$. Then one day they add a 10$/day fee to it. Now it's worth 0$. If some rich guy buys it from me, he only pays 0$. I bought something for 10k and sold it for 0. I was taxed. No one else is taxed, effectively.

FS

Felix Sargent Wed 25 Oct 2017 3:44PM

I'm going to skip over a few things on LVT, as I'd like some more information about your own proposal.
Tell me more about how you would tax the wealthy - What mechanism would you use to do it? Would you look into their checking accounts? How do you evaluate their wealth?

CS

Clay Shentrup Wed 25 Oct 2017 4:19PM

How Is tax the wealthy is only pertinent if you're agreeing that we should be taxing wealth.

FS

Felix Sargent Sun 29 Oct 2017 5:03AM

Yes, tax wealth! I agree 100%. Measuring wealth is hard though. Taxing it is even harder. What would you suggest?

CS

Clay Shentrup Mon 30 Oct 2017 6:03AM

What would a rich person do if his valuables burned down in a fire or were stolen? In order to get an insurance payment or prove to the police that a stolen good is yours, you need documentation of what you own. So there should be opportunities to roughly calculate net worth. I suppose you can just hide assets in offshore bank accounts or Bitcoin, but that carries its own risks and inconveniences.

In any case, the advent of LVT doesn't really fix anything because it's effectively a one-time tax on the people who randomly happened to be owning the land at the time the LVT went into effect. In decades, different people will be wealthy and the LVT will have no effect on them. The original landowners will be forced to eat the cost of the NPV of the LVT when they sell. Future owners are effectively immune.

Although another thought experiment just occurred to me. Suppose you accepted a one-time tax from people in place of the yearly ideal wealth tax. That would seem to work in principle, converting a revenue stream into a net present value. But then in years to come, people's wealth could change. A rich person could have a bad turn of fate, while a poor person could become wealthy. So then your tax won't really be progressive anymore. So... I can now see an advantage to an ongoing tax payment instead of one-time payments at least for some payments.

Thinking...

Oh my... I think this solved it. I was thinking that a LVT is like a one-time tax, because the buyer will just discount the purchase price by the NPV of the LVT. But he can't, because of constrained supply. An NPV actually can largely be passed on to the next buyer, because lots of land purchasers are already today paying less for land than they're willing to (deadweight loss).

What would then happen is that if the landowner gets poorer, then the marginal utility of his dollars goes up, and it makes sense for him to sell the property—because the dollars he gets for it become worth more than the loss of the land. LVT then just becomes a way to fix that deadweight loss.

Okay, so LVT makes sense as long as you only think of it as an approximation of the real ideal of taxing wealth.

FS

Felix Sargent Mon 30 Oct 2017 3:39PM

!!! Hooray discussions on the internet. Yeah, it's not perfect, but it's fungible.

CS

Clay Shentrup Wed 1 Nov 2017 7:12PM

HOWEVER... when instituting the LVT, the state should start by "buying" the land back from the owner for the present value. You want to maintain trust in government. The existing "contract" is that if you buy land, it's yours. So to just effectively take it by reducing its value to zero (with the LVT) hurts incentives.

FS

Felix Sargent Wed 1 Nov 2017 8:33PM

Yeah, it's fair. I've read arguments which say that "Rent" income is morally corrupt so screw em, take the money. I think that's far less practical. The best thing would be to take existing property taxes which combine both land and improvement tax, and adjust them so improvement taxes go to 0 and land taxes take up the rest. Then you can incrementally reduce super terrible taxes like Sales tax and increase land taxes as appropriate. Make it appear revenue neutral, and everyone should be fine.

CS

Clay Shentrup Thu 2 Nov 2017 5:40AM

I don't see how rent can be immoral. The incentive to be able to profit from rent is what creates housing in the first place.

I'm not convinced about the land vs. "improved value" argument. The point is just to tax wealth, so taxing the whole package is fine. I guess the counterargument is then you're reducing the incentive for housing supply. But trying assess the unimproved value is a fool's errand I think.

FS

Felix Sargent Thu 2 Nov 2017 7:32PM

You'd think - but Rent has an explicit definition in economics: https://en.wikipedia.org/wiki/Economic_rent

"The rent of land, therefore, considered as the price paid for the use of the land, is naturally a monopoly price. It is not at all proportioned to what the landlord may have laid out upon the improvement of the land, or to what he can afford to take; but to what the farmer can afford to give." -- Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book I, Chapter XI "Of the Rent of Land"

https://en.wikipedia.org/wiki/Law_of_rent

By definition, rent is far above the normal profit required to create a modest incentive for a person to have a place available to live.

Regarding Land Vs Improved Value: If I improve the land, I'm creating wealth by putting in time and money. This is a good and wholesome economic activity, and shouldn't be taxed anymore then sales or wages should be taxed. If I take a swamp and turn it into a useful highrise or factory I shouldn't be taxed more because I improved it more. I should only be taxed when I take something useful and make it useless.

Remember before how we computed that taxes on land wouldn't create dead weight loss? That's exactly because taxes on land won't reduce supply. If I've got one place to rent out, just because I'm taxed doesn't mean I won't rent it. I still want it to be on the market making money - it's just making less now. And I may even say that it's time to improve the property, putting more units on to the land, increasing the supply. A land value tax increases supply in the long run, not to mention the other economic efficiencies when other taxes are reduced.

Assessing unimproved land values is easy. It's called assessment. https://en.wikipedia.org/wiki/Real_estate_appraisal It's been done for ages and doesn't need to change to have an accurate valuation for tax purposes.