Linkage Fees, proposed fees on new development to pay for affordable housing, have a lot of critics. And the critics’ arguments are probably all pretty familiar by now to those who follow housing issues in the city. But for those who don’t, a quick summary: regulations that ostensibly fund affordable housing through fees on developers act like a tax on developers who pass on that cost to renters. Taxing development increases costs for developers who pull back on the production of new units; we all scramble for fewer available apartments, bid up the rent, and make everyone involved pretty miserable. This is just Economics 101 and patently true, we’re told, so get with the program you well-meaning dolts!

I hope to offer an Economics 101, or rather, a Land Economics 101 case that Linkage Fees (and other taxes on new development like Incentive Zoning) do not diminish developers’ returns and do not diminish housing supply. In fact, they are a wealth transfer from land owners to affordable housing supply. I also hope to expand the debate around affordable housing policy, which seems locked in a developer/renter rhetoric, to include land owners and the part they play in housing regulations.

The supply-side argument casts developers as suppliers and renters as demanders. When you tax something you get less of it, goes a common refrain which also makes a lot of sense. As taxes effectively make a product more expensive, suppliers are able to sell less of the product at the old quantity; they pull back on production until they find the quantity that will be demanded at the new higher price. That’s how cigarettes, coffee, gasoline, and apartments work. Tax them, price goes up, consumption goes down, supply goes down, demand and supply wiggle around each other a bit until finally a new equilibrium is established.

 

Image1 - Impact of Inclusionary Zoning-1

From “The Economics of Inclusionary Zoning Reclaimed”:
How Effective Are Price Controls? by Powell and Stringham, 2005

 

When demand and supply react to changes in price, economists call those goods elastic–the more elastic a good is, the more sensitive supply and demand are to changes in prices, and the more inelastic the less sensitive supply and demand are to changes in prices. (I will focus on supply inelasticity here because it’s more important to understanding the relationship between land owners and developers.) Gasoline, for instance, typically has an inelastic supply. A 10% increase in gas prices might result in only a 2% increase in production of gasoline. Why so little? Gasoline is a hard thing to get out of the ground, transport, and refine to the point that it runs your car. It also happens to be largely controlled by cartels who don’t see much benefit in driving down prices by producing as much as demand would support at the lower original price.

Land is like gasoline but more so. Rather than just being inelastic, it is perfectly inelastic. If the price of land goes up 10%, land supply goes up 0%. That’s just the nature of land–to be fixed in supply. Land supply is eternal… or about as eternal as it gets in economics.

The inelastic supply of land changes the supply curve from something that looks like the diagonal line above to a vertical line like below.

 

IMPACT OF LINKAGE FEES ON LAND PRICES

image2 - Impact of Linkage Fees

 

A tax on development like Linkage Fees or Incentive Zoning still “pushes the supply curve up” but because the supply curve is vertical (perfectly inelastic) instead of diagonal (elastic) quantity supplied stays the same. The demand curve for land, however, does change. It shifts down along the supply curve as the new taxes diminish potential revenue and developers pay less for the same quantity of land.

There’s a method of land valuation in real estate appraisal that states that land value is the residual of price minus potential development cost, minus the cost of borrowing money, and minus developer profit. Because of its inelasticity, land value bears the burden of changes in potential development. An important corollary to this is that when the city increases the development potential of a hot market like South Lake Union, land value again absorbs these changes minus the cost of development, borrowed money, and profit. This time, though, the result is an increase in land value.

When Linkage Fees are phased in developers will consider the revenue achievable by building an apartment, fees included, and will offer bids on land that reflect that new development reality. Because land supply is perfectly inelastic–fixed in supply–the cost of the fees will come out of the land. (In the same way a change in the zoning code comes out of or goes into the land.) And then, after developers build apartments, they will sell or rent their units based on what the market will bear. Renters and developers have an elastic relationship with each other–they change their supply and demand based on changes in prices–and abide by the familiar supply-and-demand negotiation around price and quantity.

There are possible exceptions to any theory, however. We can imagine that hill-flattening (and supply-increasing) regrades that would have been feasible no longer pencil out with post-Linkage Fees land prices, or that land owners collude to maintain prices, or that affordable run-down apartments on the verge of demolition stay that way a little bit longer. These are speculative scenarios and, although they deserve their own public airing to see which ones stand to hurt affordability, the potential benefits of Linkage Fees are very significant and grounded in the fundamentals of real estate theory and land economics.

What these theories makes clear is that by including land owners in the process of producing and supplying housing we are able to see that land owners, not developers and not renters, pay for fees on new development. Fees that go on to produce more housing supply.

20 COMMENTS

  1. Because a linkage fee only applies to land when it redevelops, it disincentivizes landowners from selling their land for redevelopment, or from developing it themselves. That means suppressed housing production, lower supply and higher prices.

    Also, if you happen to be the owner of a high value property that’s not going to be redeveloped for decades, you pay no linkage fees and are off the hook for supporting affordable housing.

    Why use this unfair, complicated, and counterproductive fee when we could just increase the Housing Levy?

    • I agree with Mr. Bertolet. Also the relevant measurements that set production are when marginal cost of producing a new unit equals the marginal revenue of producing it. By definition a linkage fee raises marginal cost significantly (otherwise it won’t raise any money). Thus production of new units will fall until marginal revenue equals the new higher marginal cost. Thus we have fewer units at a higher price. Land supply might be inelastic but construction is not.

      • It will not raise unit costs if land costs fall by an equal amount of the fee. This is the crux of the argument.

        • But it won’t, because the land has value “as is”. If I buy a parking lot, then it has value as a parking lot. It also has value as a new building, but only if I can get enough for that building to justify the cost of construction. This simply pushes up the cost of construction. Pushing up the cost of construction, in many cases, will mean that simply leaving the property alone is the prudent thing to do. There is plenty of property that can be developed, but is simply uneconomical to develop. Converting a four story building into a six story building is rarely economical. This, like every other added cost of construction, simply means that there will be more land for which new construction will not be profitable. This, in turn, will mean that less construction will occur, and prices will rise (all other things being equal).

          This rise in prices, by the way, will further increase the amount of property that is best left as is. A house in Capitol Hill (that is zoned for a six story apartment) can get a lot of money, rented out as a house. As prices rise, the amount gets higher. The value of a bigger building goes up as well, but if the cost of construction goes up high enough, then it makes more sense to just leave it as a house.

          • As to parking lot example, I’d support implementing an additional tax on the surface parking lots within the city’s urban centers to help give parking lot owners a nudge in the right direction with their penciling out development. Many cities (Portland, Minneapolis, Philadelphia) have toyed with doing something like this, but those efforts usually get tied up in court. It would penalize landowners for choosing such a poor use of high value land and get a more valuable asset. A study by Chris McCahill found that parking lots return 83 to 95 percent less property tax revenue to a city per acre than buildings do. So, I don’t think cities should be shy about altering their tax structure to discourage them in their downtowns. http://usa.streetsblog.org/2014/04/10/parking-craters-arent-just-ugly-theyre-a-cancer-on-your-citys-downtown/

    • It doesn’t disincentivize future land sales because there is no opportunity cost in selling in a post-linkage fee city — i.e., land may not be substituted for other economic goods. There is no “recourse” for the landowner by moving into other markets because land is immobile and it has no inputs that can be exchanged.

      The volume of land sales does not appear to be correlated with sale price. This was a concern of mine but I haven’t found any backing for the argument and a quick check of undeveloped land sales in Snohomish County in the last two years revealed no pattern — despite very large increases in prices over that period.

      • The obvious “recourse” for the landowner is to do nothing with the land, and make money that way. This exists in other markets as well. Require enormous amounts of paperwork, and opening up a recreational cannabis store becomes unattractive. This, of course, pushes down the value of the property (slightly) but since the owner can make money dozens of other ways, it is hardly a “tax” paid by the property owner, but simply a “tax” paid by the person who wants to create the shop.

  2. You didn’t mention that quite often, the owner is making money off of the
    property. As demand for housing grows, demand for
    other land uses grow. So someone who owns a parking lot, or a small
    building or a house is not just sitting on the property, but making
    money off of it. If the cost of construction goes up, this will be factored into the cost of the land, but only if the owner plans on building on it. That is an important consideration that you seem to completely ignore.

    >> We can imagine that hill-flattening (and supply-increasing) regrades that would have been feasible no longer pencil out.

    Yes, yes we can. These are the types of developments that have the most effect on rent. If an owner of a parking lot knows that he can get $3,000 a unit rent (or million dollar condos) by building, then he will throw away the parking lot money and build. But if rent is only $800 a month, he is going to sit on the parking lot. After all, it is keeps bringing in the cash. At some point it makes sense to build. For the sake of argument, let’s assume, with today’s building costs, that point is $1,000. Now, with this tax, that point is $1,100 dollars. Assuming demand keeps rising (however slowly) then rents will rise. After all, no one will build any units until rent reaches the higher number.

    This doesn’t mean that there isn’t a need for this money — there is. The market may not be able to provide low income housing. But it would be nice if we didn’t penalize the market when it tries to provide market level housing, especially when the market is trying persistently, diligently, desperately, to provide low and middle class income housing (e. g. Apodments).

    But the obvious problem with this system of taxation (other than the fact that it hasn’t worked anywhere) is that it is destined to fail. Either it won’t bring in enough money, or will stifle the housing market.

    Here is an analogy: Imagine if food was really hard to get, and a lot more expensive. Would you then tax the farmers that increase yields and then put the money into food stamps? This tax won’t effect the food supply, because owners of the land will absorb the cost, and we aren’t making any more land, right? Right?

    • But isn’t HALA calling for only a commercial linkage fee?

      According to your interpretation then the commercial linkage fee would slow commerical/office development, but, since there is no residential linkage fee in the plan, the housing market wouldn’t wouldn’t be constricted. Of course there are some mixed use buildings that might incur fees for their commercial portion, but, if the linkage fee is such a big impediment, then wouldn’t that drive them to build even more housing in place of offices/retail?

      • Yes, which is something relatively new in the debate. This may push commercial real estate out to the suburbs, but it will help make housing more affordable.

        • Didn’t realize this was a year old at first. Makes sense. I think there will be a big push to get commercial development in before the fee goes into effect, and even after it does a lot of projects will still make more sense here than in the suburbs. So, I don’t think this really jeopardizes Seattle’s role as a regional job center.

      • Just for context, this article was published before the HALA recommendations, when O’Brien’s linkage fee proposal was at the forefront. That proposal would’ve applied to all development.

  3. Is post for real? The author hopes to provide us a lesson in Economics
    101 and proceeds to display a profound ignorance of how basic economic
    theory works in the real world. His fundamental premise that the supply
    of land is inelastic goes against not only centuries of human
    experience, but also basic common sense.

    Here’s a simple thought
    exercise to disprove his point. Imagine you’re a property owner and I’m a
    developer. I covet your property for a development project and offer
    you $100 for your property. You know your property is worth at least
    $1,000,000 so you decline my offer. The supply of land is static.
    Another developer sees the opportunity and offers you $1,500,000 for
    your property. You like his price and sell the property to him. Voila,
    the supply of land is increased (due to nothing more than an increase in
    price).

    To believe Mr. Goldman’s post, you must accept the
    argument that price plays no role in a property owner’s decision to sell
    their property. Like it or not, that’s not the world in which any of us
    live.

    • The idea that land is perfectly inelastic goes back to David Ricardo in the early 19th Century. I checked a popular economics textbook and found that the idea that land is perfectly inelastic still holds for N. Gregory Manikaw, Harvard economist. On p. 169 of the 2008 edition of “Essentials of Economics” he states, “Because the elasticity of supply [of raw land] is zero, the landowners bear the entire burden of the tax.” The author is referring to a Georgian tax on unimproved land. The Oxford Handbook of Land Economics agrees to a somewhat lesser extent, calling land “highly inelastic in supply.” p. 734 of the 2014 edition.

      As for common sense, consider that undeveloped land is very different than other types of goods. It cannot be moved to other locations and its inputs cannot be reconfigured to produce other things because it has no inputs. The same cannot be said for cigarettes, coffee, gasoline, and housing (the structure itself) as I try to explain in the post above.

  4. What Harold said. The author’s conflating potential supply with actual supply. The amount of land is fixed, but the amount of land offered for sale is variable and price dependent.

    It’s clear that this line of argument comes from the land value tax model, which I’m still not convinced about but has some strong merits. But the author is missing that the land value tax *is based on land value* and not an arbitrary tax on square footage built. The two are vaguely related at most, and although you can’t remove land from a system by taxing it you can certainly remove construction from a market by taxing it.

  5. Great article, great argument, and thank you for having the courage to post this when you knew that most of your peers in the urbanist community would try and tear you to pieces. I think you make an absolutely solid case that for the most part this tax really is a tax on landowners and should have minimal effect on how much housing gets built here. Yet, even in this situation you get constant derision from most self-proclaimed urbanists because there is this fanatical belief that development is sacred and should be utterly free from all regulation and tax.

    Let’s be clear here: Seattle’s affordability challenges are a symptom of success, and that success has come from the smart public investments and policies that we’ve agreed to make over the last few decades. Developersdon’t build here because it’s a “good deal”. They build here because this placehas a very bright long-term outlook. Keeping it that way means continuing to make public investments and that requires money. We should absolutely try and recapture public resources in ways that are the least disruptive, but overall it has to, and should, come from the growth that our public benefits have catalyzed. Honestly, in the big scheme of decision drivers, a few small fees and taxes will pale in comparison to Seattle’s attraction as a diverse, equitable, sustainable, and economically robust place. Unfortunately the free market is pretty bad at ensuring most of those things, so public investment is required.

    • Except the linkage fee is not “small” at all. The fee is to be multiply by the entire build-able square footage. For any higher desnity apartments scenario, it can be easily as expensive as 1/2 to 2/3 of the underneath land.

      And, most developer getting financing for construction. Many plan to hold the property for longer term; those are incentivized to look at longer term. However, whether a project can be green light depends on financing of the project. That a lender are completely out of the pictures once the construction is done, they are not looking at the bright future (but looking for a definitive return of principle plus profit within 2 years). So, longer term prospect isn’t the only angle that a developer needs to look at.

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