Will a Land Value Tax stop Boom and Bust?

One of the most convincing arguments in favour of an adoption of an Land Value Tax is that it will stop, or make it difficult, for credit booms to occur. By stopping such booms from occurring, it can help ensure that the economy, especially the financial system, doesn’t become to indebted and thereby come unstable enough that a crash will ensue. If a LVT could have such an effect on the economy, then a LVT would go a long way in not only funding government activities but also ensure that there is less a need for governments to run deficits to alleviate the economic condition that result from a crash.

The benefits that a Land Value Tax could give to the economy in the wake of what recently happened in 2008 should be very appealing, if true. Such a benefit should make anyone support a land value tax, even if they don’t agree with the philosophical principles of Georgism in regards to the nature of land and its appropriation.

What is it that causes boom and busts? This question is a very theoretical and abstract question, primarily because it makes no specific reference to any specific economic event. Many different theories exist why booms and busts exist from the belief that government interference in the economy causes such phenomena to the view that too much money or too little money exists within the money supply.

The Georgist’s theory relates the phenomena of credit formation with the appropriation of land and its resultant speculation afterwards. Booms occur because far too much credit exists within the financial system, making the economy too indebted. Such levels of debt make the economy unstable as far too much income ends up being spent of deleveraging rather than economically productive activity. Which is what happens in a bust: debt deflation. Georgists will hold similar views on the cause of economic depressions as Hyman Minsky and Irving Fischer.

So what has a land value tax got to with the credit cycle? Georgists go a step further than Minsky and Fischer and try find the cause of the credit cycle in the first place. It all has to do with the price of land and how it is acquired. Land speculation is a phenomena in which land is treat as an asset to gain money from without doing any productive work on such land. Essentially, the value of land increases making the cost of owning a home more expensive. This increases the overall size of mortgages, which are deemed assets to the banks. As the rise in asset value occurs due to inflating prices of mortgage loans and the security asset that underpins them, the bank has a greater amount of assets on its side of the balance sheet, Selling such mortgages to other financial institutions gives the bank ability to expand its reserves, which gives the bank a greater ability to issue more loans elsewhere in the economy. Whether that be business loans, takeover loans, home loans or even further mortgages. Such an expansion of reserves is made possible due to the fractional reserve banking our financial industry operates.

Such land speculation, which can also be called rent-seeking, is the root cause of how credit expansion forms. Credit expansion leaves us with more money to buy stuff thereby inflating the economy. Greater levels of credit fuel more land speculation which fuels the credit boom even further and further. More credit will mean more money floating around making it easier to conduct other forms of economic activities that may, or may not, be productive. This cycle exists until the system becomes too unstable and destabilises due too much leverage within the economy, causing a spell of deleveraging causing a recession/depression.

The land value tax is designed to tackle land speculation by enforcing the principle that when such speculation occurs you pay a larger amount of money in tax, offering you a disincentive to raising the value of land. As no such incentive exists to speculate on land, the value of land will not increase at dramatic rates ensuring that a quick rise in the asset value of the banks wont occur. This makes it harder for the bank to build up reserves so that it can issue credit. Indirectly, the land value tax imposes a discipline to the creation of credit that wouldn’t exist if we didn’t tax land values, such as we don’t nowadays.

There are three principles objections to this argument. First, that land is not the principle cause of the vast amount of credit being formed in the economy. Second,  the argument ignores the fact that Minsky argues that credit formation is inherently unstable.

First, there are two ways in which land speculation can lead to an expansion of credit. We have the initial act of the issuing of a mortgage which accounts for land and house price [as the former helps determine the latter] by a bank placing such an act onto the asset of the bank, thereby the bank issues deposits as a liability which is a form of credit. This is the immediate way in which credit expansion.

We then have the issuing of mortgage backed securities [MBS], home equity asset backed securities and collatarised debt obligations [CDO]. These are financial instruments used to help finance particular activities which using conventional forms of finance couldn’t occur within the market. Such instruments can help provide greater market liquidity than would otherwise exist due to the type of asset, i.e. mortgages, in question. It’s this greater liquidity to help finance other ventures which helps create even more credit than would otherwise exist. These instruments themselves are forms of credit so the natural use of such instruments expands the quantity of credit. These instruments, especially CDO’s and home equity asset backed securities, are based upon high risk mortgages assets.

Take MBS’s leading to the financial crisis, they were used to finance subprime mortgages. Subprime mortgages were loans to allow those who could not normally afford a home to go and buy one. The introduction of such mortgages what Minsky would call Ponzi finance, primarily due to the entirely speculative nature as to whether the mortgage would get paid off. The introduction of Ponzi finance into the financial system is what ensures such systems become unstable.

So what has a land value tax got to do with this second way in land prices affect the formation of credit? These securities tend to be very risky assets. If the housing and land markets are booming though, with little empirical evidence plus market euphoria, what Keynes would call ‘animal spirits’, to point to prices not to drop, then financiers will calculate the risk of defaults in the collateral of what structures such instruments to be low. Thereby making such securities seem safer to trade. This is acknowledged by the use of credit agencies foolishly given out AAA rating to CDO’s.

The theory of the land value tax tells us though that such booms in land prices would not occur, so such animal spirits could not develop for financiers to think that these instruments were much less riskier than they actually were. The risk of default in a market in which land prices were more stable would increase due the dynamism of the market meaning home owners would not necessarily to be able to finance their mortgage increasing the probability of default.

Some Georgists will find such reasoning problematic because the implementation of a land value tax would need reforms to the land market, meaning no mortgages could exist to finance such land as land would be a commonly owned asset. The tax would be a rent paid to society for the exclusive usage of commonly owned. Due to this, the mentioned securities and financial instruments could not exist as there would be no mortgages to secure them. Such concerns are worth noting primarily due to the fact the implementation of the land value tax will obviously shape the overall economic structure, specifically in the land market.

To answer the objection directly, the size of the market of mortgages, subprime mortgages and financial instruments tells you that a large part of the financial sector is heavily and directly related to the land market. It would take a thorough investigation on the dynamics of the financial system to see how far land speculation accounts for the tolerance of the financial system to create so much credit. In other words, the land value tax will go a long way in reducing the size of credit formation in the financial system. The usage of other taxes may be needed, but we are not arguing for a single tax.

IMF Diagram on the Theory of CDO's
IMF Diagram on the Theory of CDO’s

Third,  it is true the argument fails to take on board that fact. However, the implementation of a land value tax should reduce the amount of credit than can be formed by a significant factor in the economy. This should mean that when busts occur, they will also be significantly smaller in size. They’ll be more manageable for the market and state to respond to the challenges that busts provides. So the land value tax would act as a regulation on the scale of boom and busts rather than a device to eliminate. Mitigating busts is a good reason to implement the land value tax.

Gareth Mawer
I consider myself a left libertarian committed to promoting the philosophy of liberty, even though I do not always support proposals that are normally considered libertarian. Georgism and mutualism have had profound influences over my beliefs, though I'm not afraid to digress from them were necessary. My mains interests are politics, economics and philosophy.
  • Paul Harnett

    Any thoughts as to what to do with the proceeds of the tax? We discussed Land Value tax as a basis for a world basic income at our recent conference

    • Hi Paul,

      Sorry about the late reply.

      I fully support using a LVT to fund a UBI. I also think the proceeds should be invested in developing advanced technologies, universal health care systems and ensuring institutions in the marketplace exist to ensure they function as theory suggests they should.