Thursday 17 January 2013

O. Land values are real capital or wealth

• Land is just capital like any other kind of capital (skip to article)
• House prices will plummet and wealth will be destroyed (skip to article)
• House prices will plummet and millions will be trapped in negative equity (skip to article)
• House prices will plummet and banks will go bankrupt

 (skip to article)
• "Banks pay lots of tax. Without them, the country will go bankrupt" (skip to article)
• House prices will plummet and the tax base will disappear (skip to article)

1. "Land is just capital like any other kind of capital"

No it's not. That's just brainwashing.

First we have to distinguish between selling prices and rental values. Rental values are merely a measure of scarcity of land at any particular location, i.e. anywhere with that particular combination of work/leisure opportunities. Rents are pure monopoly (or cartel) income, and no matter how much land is divided up or how widely it is held, those are still shares in a monopoly.

Consider: a utility company with a monopoly of supply is privatised and shares are freely traded and widely held. The underlying asset is a monopoly. However dispersed the ownership is, it is still a monopoly. And if you want to own shares in a utility company, you can only buy them from somebody who already owns shares in that monopoly (a cartel). So when you buy shares, you are paying a premium to join the cartel which owns the monopoly (and itself earns a premium from having the monopoly). Buying land is no different.

a) Selling prices are merely the capitalised value of rental values, i.e. the rents which the owner can collect or enjoy himself, net of tax. My workings tell me that the discount rate being used is (at present) about 3%, so land with a site premium of £10,000 a year sells for £330,000 or thereabouts (£10,000 ÷ 0.03 = £333,333) If the house on that site costs £100,000 to build, the total price is £430,000. The house is real capital (the cost in man hours and materials to replace it), the land value isn't.

For example, if interest rates rise and the discount rate increases to 4%, the selling price of the land is now only £250,000.
Q: Where did the other £80,000 go?
A: Nowhere, it was never there in the first place. The purchaser took a gamble on interest rates not going up and lost. The bank won.

Q: What is the source of wealth for the bank's winnings?
A: The purchaser's earnings. He'd have been earning that money whether he took the bet or not.

Q: Has the nation as a whole become richer or poorer?
A: Neither nor. Swings and roundabouts. Net savers are happy because they have higher incomes, net borrowers are unhappy. Land purchasers are happy because land is cheaper, land sellers are unhappy etc. Overall, there is a small marginal gain.

b) If you took out a large mortgage to buy that house and prices fall, then oo-er, you soon notice that the land value was not real but find out to your cost that the debt very much is, and your mortgage payments cost more than it would have done to rent the place.

c) Ultimately, only rental values are real (and that is what the banks tap into). And what are rents? Do they add to wealth or merely shift wealth from one group to another? The landlord cannot collect more wealth that his tenants can crate, minus their basic minimum living costs.

d) In the case of owner-occupation, no cash changes hands but the owner-occupier derives a benefit and thereby places a burden on everybody else. Once the best sun-loungers by the pool have been taken, everybody else has to sit further back, and some people will end up having to sit on the floor or going elsewhere.

e) Or imagine that the local council sold off the entire road and pavement in front of your house to a private infrastructure fund. From now on, you have to pay them for the privilege of crossing their land between your house and the nearest "free" public road. What sort of toll can they charge you for this? Well, pretty much the entire location premium of your house, even if that is thousands or tens of thousands of pounds per year. Maintaining the road and street lighting costs them tuppence ha'penny and they make a handsome income. Even though the infrastructure fund can show that land as an asset in its books and derives income from it, that is matched by the fall in value of your land. No net wealth has been created, has it?

2. "House prices will plummet and wealth will be destroyed"

No, because land selling prices are not wealth, see above, and to a large extent they are merely the flip side of a credit bubble. Did people all become wealthier during the last house price bubble, which was pretty much a global phenomenon? A minority did, but by and large, people are now worse off: older people have been tricked into over-consuming (mortgage equity withdrawal) and under-saving, all recent purchasers are saddled with bigger mortgage debts, and younger people are completely screwed. They have a choice between taking out a huge mortgage or paying rent for decades.

On a far more mundane level, what if house prices had stopped increasing around the year 2000? To say that a halving of house prices is a destruction of wealth we must also say that when the government sacrifices huge chunks of the economy to propping up house prices it creates wealth, which cannot possibly be true.

If my parents had known when they bought their house for £2,000 in the 1960s that they could sell it £100,000 thirty-odd years later, would they have made the decision to buy? Yes. Would it still be a good investment if they knew that they would be able to sell it for £100,000 fifty years later? Also yes. Would they still have made that investment and been happy with it if they'd know its potential selling price would rise from £2,000 to £200,000 and then fall back to £100,000? Yes. The middle bit was never real money as they stayed living there.

And if somebody bought a house in 2000 and the potential selling price stayed the same for ever, would they be happy with their purchase decision? Yes of course, it still wouldn't have been a bad investment. What if that person had completely ignored every single article about house prices, until after LVT is introduced and notices that his house can still be sold for as much as he paid for it but that his overall tax bill had gone down, why would that person be any poorer or less wealthy?

3. "House prices will plummet and millions will be trapped in negative equity"

It makes for a great sounding headline, but it's just the Home-Owner-Ists shedding a few crocodile tears for recent buyers while panicking that the lovely house price cash machine will stop spewing out the free money and that, Heaven forfend, they might have to start paying something back.

Fact is, before we worry about negative equity, let's look at the time it takes to pay off a mortgage. Please refer to the Zoho sheet on the Tax Calculator page.

The default figures are for a typical recent purchaser household with a large mortgage, i.e. a couple on median male and female full time earnings, two children in a £200,000 home. They would pay £13,000 a year less in tax. That can go towards paying off their mortgage.

Let's assume that they have an 80% mortgage (£160,000) at 3%, repayable over 20 years. That currently costs them £896 a month. If they put the whole of that £13,000 towards paying off the mortgage - and assuming that house prices fell by half (they'd fall by nowhere near that, of course), they will be out of nequity within three to four years and will have paid off their mortgage in full within seven or eight years.

After that they are £24,000 a year ahead of the game (no more mortgage, much less tax) for the rest of their working lives.

You can enter your own figures and see what sort of results you get.

The other point is that banks could simply be made to write off all nequity. Because of the fairly straight line distribution of mortgages by loan-to-value, the amount which banks would lose is surprisingly small. Even if house prices were to fall by half (wild exaggeration), banks would have to write off about 25% of mortgage assets, which is about 15% of their total financial assets, which is easily made good with debt-for-equity swaps.

This doesn't mean that banks will actually lose any future income, as they can just bump up interest rates. So banks are currently collecting 3% interest on £1,200 billion mortgages = £36 billion income. If mortgages are written down to £900 billion and interest rates increased to 4%, monthly mortgage repayments stay much the same and banks' interest income is much the same, so what's the problem?

Also remember that nequity is largely a psychological thing. It's just not nice to have a mortgage larger than what your house is worth and banks make it difficult for you to move. Well that's for them to sort out, isn't it?

4. "House prices will plummet and banks will go bankrupt


Again, it's a great sounding headline but it's simply not true.

a) Let's start with those recent purchasers for whom the Homeys were shedding crocodile tears in the section above. If we assume reasonably sensible purchasers took out mortgages of no more than four times salary and have been keeping up the repayments on a twenty-five year mortgage, then even if house prices were to halve immediately under LVT (which they wouldn't) and the underwater amount of all mortgages were written off, the total write off would be only 10% of all mortgage debt (about £120 billion out of £1,200 billion). Such a write-off is unnecessary as it will be recent purchasers who make the biggest overall tax savings, but hey, it'd be nice to get one over those private rent collectors, the banks.

b) Even if we take all mortgage borrowers, including those who have constantly be remortgaging upwards to finance over-consumption, the figure is not that dramatic. Only half of houses have mortgages them and there's a fairly straight line distribution of loans-to-value, i.e. a tenth of borrowers have equity of 10% or less; a tenth have equity of 11% to 20% and so on.

So even if house prices were to halve (which they wouldn't) then only a quarter of all mortgage debt would be underwater, and even if all borrowers in negative equity were to lose their jobs, default and declare themselves bankrupt, and the banks were to repo all such houses and sell them (all highly unlikely assumptions), then the total loss to the banks would be no more than a quarter of all their residential mortgage assets (£300 billion out of £1,200 billion).

c) UK banks claim to have total assets of £6,000 billion or something, so that £120 billion or even the £300 billion is a drop in the ocean, and nothing which can't be sorted out with debt-for-equity swaps. Ordinary depositors would not lose a penny.

5. "Banks pay lots of tax. Without them, the country will go bankrupt"

Again, not true.

a) The total taxes borne plus taxes collected by the financial services sector (mainly PAYE, with bits of corporation tax, Business Rates, irrecoverable VAT, Stamp Duty and so on) is in the order of £63 billion, allegedly, about one-tenth of all tax receipts (hardly surprising as financial services' gross income is about one-tenth of GDP, an alarming figure in itself).

b) Beyond a certain level, and we are way past that level, banks do not add to GDP, they reduce it. If the bankers consumed less of our wealth, then the economy would do better and the extra tax receipts from the rest of the economy would more than make up for the loss from banking.

c) The crude analogy is crime. Let's assume that we semi-legalised burglary and taxed licensed burglars at 50% of their ill gotten gains, the amount of tax they pay would be quite significant. But burglary is bad for the economy. Would those people who are crying out for burglary to be made illegal again be shouted down on the basis that burglars are paying tens of billions in tax?

d) And collecting tax from banks is easy, you just increase the bank asset tax rate to whatever is the revenue maximising rate. That rate is probably about 2% per annum (on UK related lending only, obviously), being the spread between lending and deposit rates which banks can earn in their sleep from dull and boring mortgage lending and taking deposits.

e) The advantage of taxing their "rental income" via a bank asset tax over taxing their stated profits via corporation tax/PAYE is that it incentivises them to get into more profitable lending, such as lending to businesses. The effective tax rate on more profitable, risky and productive lending will be correspondingly lower and their retained profits correspondingly higher.

f) Even if bank balance sheets fell by three-quarters, we'd still be getting £30 billion a year from them in bank asset tax, with flat income/corporation tax and Business Rates on top of that. So yes, tax receipts from the sector would fall, but so what?

6. "House prices will plummet and the tax base will disappear"

a) This ignores Rule One of LVT, that it is a tax on annual rental values and not selling prices. Rental values across the country are very stable in most areas from year to year, and for every area in which they fall there is one in which they increase and the overall trend has been steadily upwards since the Black Death, rising with wages (see shorter term chart here).

b) Even if LVT were set at a percentage of selling prices to get the ball rolling, it would be set at a percentage of selling prices at a fixed point in time before the introduction of the tax (just like Council Tax), and so fluctuations in selling prices thereafter would simply have no impact on the tax base, then at the next revaluation, we shift to taxing rental values (which means adjusting LVT rates up or down a bit).

c) We can illustrate this by looking at the closest thing the UK has to LVT, which is Business Rates, which is a set percentage of the total rental value of commercial land and buildings, selling prices are simply completely irrelevant.

Total Business Rates receipts have increased steadily and smoothly, from £18 billion a year before the bubble in the chart below, to £20 billion at the peak and £23 billion in the year that prices levelled out again.

Chart from the Bank of England's Feb 2010 Inflation Report (click to download Powerpoint slides, via the ever reliable Tutor2U:

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