Friday, March 23, 2012

Taxes and the distorsion on the market

The article below from the National Real Estate Investor magazine explains a difficult situation that real estate investors are experiencing in Arizona with the recent plunges in real estate prices. This sort of upside down situation where the city is still looking for revenue but the commercial real estate is not able to provide it creates a difficult situation. The booms and bust we experience with central banking is not expected and understood by everyone, particularly city officials reluctant to lose the tax revenue from the recent boom.

Via Wikimedia
But while reading this article, it somehow reminded me of how property taxes can distort the market, and one good example of this was in northern Europe in the 15th and 16th century. On a trip I've done over there over a decade ago, I saw a very interesting street in a city in Brittany (north east part of France). This street contained several half-timbered houses such as those seen in the image enclosed. One of the first thing that comes as a surprise is the way the upper floors project over the lower ones and my first question to the locals was "how come?". The person I asked the question said the property taxes back then were based on the width of the street frontage they used. So owners would benefit by gaining square footage from the untaxed upper floors for any narrow houses with several floors.
Remembering this pick my curiosity and I had to do a bit more research on those houses. I didn't remember how this type of house was called to begin with. My first surprise was to learn they date back to medieval time. When you consider that anything older than a century or two anywhere in North America is amazing, I was next to one build more than 500 years ago without knowing it. The ones I saw were quite old, the wooden frame were showing their time. The article I found below did confirm taxes were likely the reason although they brought up the fact it also helped protect from rain and snow:
Often the upper floors project out over the lower ones. There are several conjectures as to the reasons for this. One is that houses in cities were taxed on the width of street frontage they used. So a high, narrow house saved the owner money, yet to maximize interior space the non-taxed upper floors were lengthened. Also, the projecting upper floors helped protect the lower house from rain and snow in the days before gutters and down-pipes.

Via Wikimedia
But I don't think this shows the most distortions you could have from taxes. As I've heard from that same conversation with this individual is that houses at some point were taxed based on the amount of windows they had. So one cannot be surprise to learn that owners were patching up some of their windows. This Window tax, as it was called, was in force in England, Scotland and France in the 18th and 19th century. Imagine what a "door tax" would have done...

Thanks to Mr. G Cameron, I've learned that anything with a roof was taxed a few decades ago in England. One of the major casualty of this law were inhabited old castle. One example given was Redcastle which the owner removed the roof to avoid the tax, unfortunately, the castle is too dangerous to enter and visit today. See Redcastle

Governments are political animals that like to grow. Back then, since nearly all the countries of the world were using gold and silver as money, they had to be creative in the way they taxed their people in order to extract more. Since today the entire planet is on a fiat paper currency system, it is predominantly during the times of busts that local government income suffers...

Back to the original article

Which brings us back to the tax problem in Arizona. As much as governments like to grow, they do not like to shrink and during those time of bust they will try to minimize this impact at the expense of the owners. So we have modern distortions that comes in a financial form today. The first distortion comes from central banking adding fuel to real estate booms through artificially low interest rate which makes them just bigger bubble. We certainly cannot blame city officials for the action of the central banker but the second distortion is how city officials will increase their budget as the tax income comes in - basically everyone get caught in this fever - and are slow to react when the bust comes.

What they should actually do now is realize the city has to cut drastically to near pre-boom level spending and reduce the tax pressure on the property owners. Although I'm leaning towards libertarian values of small government where the market provides almost everything (libraries, parks, roads, etc), taxes needs to be accessed and collected with as little overhead and complexity introduced in the market as possible. Just as you want a truck to carry has much payload and as little overhead, the taxation process should be minimal and least disruptive.

Commercial properties values are based off the income they produce and the given current market cap rate. So, one way could simply be to tax based on the income the commercial property generated the prior fiscal year that was filed to the IRS, with a very minimum base amount in case the property was empty over that year.

If you've heard of other strange laws from the past that impacted the architecture of properties, we are all hears and would be interested to learn a few more funny and interesting ones.

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