New paper: Developers pay developer charges

I have a new paper out — Developers pay developer charges in Cities: The International Journal of Urban Policy and Planning.

In this paper, I estimate the economic incidence of developer charges (taxes paid upon approval to use land for a higher value purpose) using a natural experiment in Queensland, Australia, where a surprise political announcement varied the charges. Using data on developer charges and dwelling prices during this ‘natural experiment’ period I estimate their economic incidence. The data clearly shows that the administrative incidence on the landowner (developer) happens to also be the economic incidence. An increase in the charge comes at no cost to the buyer of a new dwelling but instead decreases the land value by an equal amount.

The motivation for doing this analysis was an article in The Conversation that suggested the opposite — that the economic incidence was on the buyers of new dwellings, against all logic and reason. In fact, this research showed a significant correlation between developer charges and home prices at a ratio of 1:4. Erroneously interpreting this relationship as causal would mean that increasing charges by $1 would increase home prices by $4.

Can you see the nonsense here? If there really is a causal link property developers would be lobbying to massively increase charges in order to earn a 400% markup on them! In reality, the development industry has been lobbying hard to remove them.

In my paper, I demonstrate the problem with this causal interpretation, which arises because the variation in the developer charges is due to the way they are set by regulations. The regulations state that the charge per new dwelling of 2 bedrooms or less can be a maximum of $20,000. The charge for a 3 bedroom or larger dwelling can be a maximum of $28,000. Because councils have no incentive to charge less than this maximum this was the size of the charges in their data. The regression analysis merely showed that the average 3-bedroom or larger dwelling is 4 x $8,000, or $32,000, more than the average 2-bedroom or smaller dwelling (controlling for other quality and location factors).

Because my study covered a period where surprise political decisions varied the charges themselves for each dwelling type, my analysis shows no relationship. In fact, if you take out this surprise variation in my data and leave the charge at the fixed price for each size dwelling I can replicate the earlier results of a 1:4 correlation.

Why is this important?

This result is significant because the economics of property is almost the exact opposite of the economics taught in most modern university degrees, and bad economics is being used to justify bad policy. All too often I see the following implicit assumption about causality:

Cost of capital ⇒ Rental price of capital.

If you increase the cost of investing in capital, you increase the rental price of capital. That is the logic behind the idea that developer charges, or a land tax, can be passed on to users.

But this clearly makes no sense in the case of land. Land is costless to produce. It is obviously not costless to buy it from someone else, but ultimately, there is no prior investment that provides its value. It is merely a legal right to claim certain incomes associated with that location. So for land (and ownership rights in general), the direction of causality must be:

Rental price of capital ⇒ Cost of capital.

This is not a secret. It has been widely known for hundreds of years in the property valuation profession, which uses variations of the ‘residual value’ method to isolate the pure rental price of land and use it to determine the cost (price) of land.

So what?

Vested interests in the property industry continue to argue that shifting the tax base to land will increase the cost of housing — after all, they argue, the rental price is caused by the cost of land plus other costs, including taxes and charges.

We know this argument is bogus because it simply begs the question that if prices come from input costs, why does land have any value at all? All land rents should be zero.

And again, if the rental price of capital was the result of a summation of costs, the property industry would have nothing to fear from increasing developer charges, as they could pass on those costs in the price of new dwellings.

One step further

We can take this logic another step and see that because the economic incidence of land taxes (or development charges) is on the landowner, increasing these taxes can encourage more development sooner since it reduces the payoff from delaying investment in new housing.

Consider the table below. It comes from my paper. I use it to demonstrate the changed incentives to delay or bring forward new housing development from increasing land taxes (which effectively decreases the net rental price of land).

The table shows three scenarios where the discount rate is 5%. In each scenario, the price in time one (t=1) reflects the expected rate of growth. The present value (PV) is the price at t=1 discounted at the 5% rate. Where that present value is higher than the current price, there is an incentive to delay sales, which feeds back into delayed construction [1].

If the rate of price growth is higher than the discount rate (the rate of return on the sale price available from investing it elsewhere) it makes sense to delay the sale to get the higher price (Scenario A). If the rate of price growth is low, there is an incentive to bring forward sales to get your money out of this property to put it somewhere else an get a higher return (Scenario C).




The property industry likes to promote the myth that they would never delay selling. Yet, when I worked for a major property developer during a price boom period, we did exactly that. The decision was made to close the sales office one Saturday because there were too many sales. These rapid sales meant that the price was too low and that delaying the sales would fetch a higher price (and a higher PV of that future price). So instead of selling the whole building in one day and starting construction, the prices were raised, and it took years afterward to sell the whole building and massively delayed construction.

The absolutely crucial lesson in from the Scenarios in this table that the imposition of a developer charge can turn Scenario A into Scenario C by reducing the net revenue from each future dwelling sale to a developer due to the charge. For example, if a charge of $10,000 is announced to be imposed in the next financial year in Scenario A, it becomes Scenario C in net terms, and the developer will prefer to bring forward planning applications to get a lower charge and incur sales in the current period.

Increase taxes on land to get more construction, not less!

To be clear, this is not some crazy idea I just invented. This is the standard result of real options theory, and it applies equally to increasing costs to landowners and decreasing their future development options. Here’s a 1985 paper from the AER making the point.

… the initiation of height restrictions, perhaps for the purpose of limiting growth in an area, may lead to an increase in building activity in the area because of the consequent decrease in uncertainty…

Imposing height restrictions can turn Scenario A, where future revenues (price x number of dwellings) are higher because of the option for increased density, to Scenario C, where future revenues are lower because the number of dwellings able to be built on the site is fixed. This brings forward sales and construction.

In sum

My new paper is a small contribution that demonstrates the well-established economics of property markets, but which flies in the face of conventional theory. Understanding land and property markets helps to understand how backward the standard economic understanding of ‘capital’ really is.

fn [1]. Another thing many economists get wrong about the property market is they ignore the fact that most sales come before construction, not after. This means that when people just say “increase supply” they don’t realise that market incentives mean this will never happen — supply only responds to demand. Only a housing developer without a profit motive would increase supply at a rate that would depress local prices, and yet we hear nothing from the ‘supply-siders’ about the creation of a public housing company that could do just that.

Facts don't matter

Review of Win Bigly: Persuasion in a World Where Facts Don’t Matter

I can save you $13 and summarise this book for you — a rich white guy from New York dating a model half his age who didn’t travel outside of North America till age 59 finds Donald Trump persuasive.

There is more to it than that. But according to Win Bigly’s author Scott Adams, the first piece of information about a topic matters when it comes to persuading. It’s called Anchoring.

On its surface Win Bigly is a lesson in the art of persuasion. Adams uses his experience blogging about the total misreading of Trump’s election persuasion by the established media as a backdrop to his own lessons in persuasion. He also provides a language to help understand and communicate persuasion techniques — The High-Ground Manoeuvre, Two Ways To Win and No Way to Lose, Setting The Table, Visual Persuasion. It’s all good stuff. To anyone who has an interest in cognitive science (not many of us), and skills in objectivity (even fewer of us), a lot of the book is a well-packaged presentation of established material paired with Adams’ persuasion hunches. For everyone else, you will find a lot of new and interesting stuff in there.

I probably enjoyed the book more because I have some views in common with Adams that few seem to share. For example, for years I have been bamboozled by people who have a love of facts yet continually try to persuade with facts. The facts are clear on this — facts don’t persuade. So why ignore this if you are a fact-lover? One of Adams’ main points, as you might have guessed from the title, is exactly this.

I also wrote about the misreading of Trump here. And of Brexit here. So I clearly do identify with Adams, which gives him a headstart in his persuasion.

But while I agree with much of his analysis of Trump’s persuasion methods, Adams persuaded me that he is, like many (most?), a bit of selfish bloke with a chip on his shoulder. This explains my opening sentence.

You see, despite repeated humble-brags throughout the book, ‘good guy’ Adams ends by changing the tone and being a dick about Clinton’s proposed estate tax, responding to it as follows.

This was personal. I started life with almost nothing and worked seven days a week for decades to build the wealth I have now. I wasn’t in the mood to let the government decide what happens to my money when I die.
...
But once Clinton announced her plans to use government force to rob me on my deathbed, it was war.

He also recites the nonsense double taxation myth favoured by one-percenters. Maybe it is good persuasion if your audience is other rich people or those who believe they will be rich when they die. To me, an expert in economics and taxation, it is idiotic and stupid. Inheritance taxes make the world better and fairer. These views starkly reveal a naivety and selfishness. It shows me that for all the interesting things in the book that I agree with, a lot of Adams’ filter of the world seems to be him identifying as a rich guy with German heritage and conservative tendencies who wanted Trump to win to validate that. He was very lucky to get his prediction right. As he admits.

Maybe one reason that I have had this reaction is that unlike most readers of Win Bigly I am simultaneously reading The Great Leveler: Violence and the history of inequality from the Stone Age to the twenty-first century. But that’s another story.

The book is worth a read if you want to better understand the Trump phenomena. It may persuade you to drop some of your beliefs in “facts” that don’t really stand up to scrutiny. But for all the insight in the book, I guess I was disappointed to see that even those most alert to our tendency to believe in myths, or facts that suit our own interests, are driven by their own myths.

Postscript
One thing I have always found strange is how rich conservatives who ‘worked hard for their money’ want their children to never have to by leaving massive inheritances. At the same time, many will promote how noble the experience of poverty and hard work is for everyone else’s children. Such reasoning ignores the fact that plenty of people have usually worked harder for less money — after all if Scott Adams went on strike no one would declare it a State emergency. Apparently, you get what you deserve in life because you work hard for it, unless, of course, you are born into the right family. Life isn’t fair. But that doesn’t mean we shouldn’t make it fairer if we can.

Evolutionary market competition

One of the best models of competitive markets in an economy is an evolutionary one that embeds the ideas that cooperation and competition operating at different levels. The basic ingredients of the evolutionary approach are:

• Variation - A process that varies inheritable traits at any reproducible unit (organism, tribe/colony, cell).
• Selection - A process whereby the environmental conditions determine the reproductive success of a reproducible unit.
• The result is a process of adaptation.
• A firm (or any organisation) can be considered a reproducible unit.
• The market and society as the environment which determines success and reproduction
• Relative success matters for reproduction (firm growth and continued existence) rather than an absolute success.
• Success depends on the local environment at each point time - there is no timeless correct way to do things, and there are environmental niches (sometimes temporary).
• The success of markets in delivering efficient output is, therefore, the result of within-firm cooperation, and between-firm competition.
• Without market level selection pressure, firms can become internally competitive, losing efficiency.

These ideas might make more sense with an example.

The core approach 
Imagine that within a firm every interaction amongst employees can be either cooperative, which results in improved production efficiency, or competitive, which helps one of the individual employees (conditional on the other being cooperative), but reduces the overall efficiency of the firm.

It might be as simple as employees wasting resources blaming others for failures rather than working together to get an efficient outcome, or it could be as competitive and nasty as sabotaging the work of others in the firm to make yourself look good, which might be good for the individual, but bad for the company.

Perhaps the example of Amazon can help get your mind around this idea:

At Amazon, workers are encouraged to tear apart one another’s ideas in meetings, toil long and late (emails arrive past midnight, followed by text messages asking why they were not answered), and held to standards that the company boasts are “unreasonably high.”
The internal phone directory instructs colleagues on how to send secret feedback to one another’s bosses. Employees say it is frequently used to sabotage others. (Source)

The table below shows the stylised conflict between individual choices to cooperation or compete within a firm. For two people (A and B) who randomly meet within a firm, they can both cooperate and earn an individual payoff of 10 each (top left cell with A, B individual payoffs listed), giving the firm an overall payoff of 20. Or, one person can ‘defect’ while the other cooperates, giving that person a payoff of 15, but only a payoff of 0 for the cooperator, and an overall firm payoff of 15, which is lower than if people were cooperating. And the bottom right cell shows the payoffs if both people are competitive (the defect from cooperation), giving each a lower payoff of 5, and the firm a payoff of 10 (the sum of both people’s payoff).

Clearly, the best thing within a firm is for all interactions to be cooperative to get the highest total firm payoff, but there remains an incentive for each individual within the firm to occasionally defect and get a higher personal payoff.

Now, let’s think about market competition operating at a firm level. With more competition, would we expect the evolution of market to result in the success of more competitive individuals?

The diagram below shows a serious of three selection stages over rows from time one to time three. Each small table is an environmental or market niche, and each colour represents a single firm. So in the top row there are four firms (blue, green, yellow and orange).

Each small table shows in column N the number of cooperators or defectors within the firm. So in the top row blue table, there are 20 cooperators and no defectors in the firm. The next column, P, shows the average payoff to each person from random interactions amongst other firm staff. In the top row of the blue table the average personal payoff is 10 because all 20 staff are cooperators and every interaction with another cooperator in the firm gives a payoff of 10. The total firm (or group) payoff is in column G and is 200 in this instance (20 people getting a payoff of 10 each).

The next firm in the top row in green has within it 15 cooperating staff, and 5 defectors. The average personal payoff for the cooperators in that firm is 7.5 because they have a 1 in 4 chance of dealing with a defector, and a 3 in 4 chance of dealing with another cooperator. The defectors have a higher personal payoff of 12.5 for the same reason.

Moving across the top row, the yellow firm has 10 cooperators and 10 defectors. This firm is a nasty place to be, and half the time the firm is busy with staff blaming each other and not producing efficiently. The payoff (or total efficiency) for the firm is much lower, at a total of 150.

The last orange firm is mostly defectors, perhaps an extreme version of our Amazon example. The total payoff for this firm is just 125.

Outside these tables on the right side is a column N, which is the sum total of the number of people who are cooperators or defectors in each time period. In time one there are 50 cooperators amongst the firms (20 in blue, 15 in green, 10 in yellow, and 5 in orange), and 30 defectors.

Moving from time one to time two, or going down a row, is a selection stage in the competitive evolutionary game of market competition amongst firms. That is, only the most efficient firms survive, and the least efficient die off from lack of customers from their poor value products made inefficiently. In fact, in this example, the most efficient firm expands to take up the market niche left by the firm that dies off.

So when we move to the second row in time two, the least efficient orange firm has died off, and the most efficient blue firm has expanded to satisfy that market niche.

But notice this. When we add up the total cooperators and defectors working in all the firms in the market at time two, there are now 65 cooperators (15 extra), and 15 defectors (15 less), compared to time one. That is, competition at the firm level has led to the selection of the most internally cooperate firms to survive, not the most internally competitive. Going down one more row shows the new relatively least efficient yellow firm also dies off. Thus, what works at one point in time does not work at all points in time, and success in this game is only relative to others in the market environment.

The economic lesson from this simple example is that competition is good when it provides a selection mechanism that favours cooperative and efficient groups (or firms) that enable total production to expand. Variations that improve efficiency and cooperation within firms will, over time, be selected for by consumer choices in the market.

Within-firm competition with external costs
Let us now think about larger firms that have multiple departments making multiple products with a variety of different customers. We can also think of large bureaucracies in general, including government departments. Perhaps the above example has led you to think that competition within company departments might be a good way to select for the best ones. Unfortunately, this approach has a huge incentive problem, as the relative success of one department might be due to passing off costs to, or sabotaging, another. Thus, within-firm competition that results in an evolutionary selection process is very risky, and it is well known that 'silos' in firms can results in conflict between what is best for each silo, and what is best for the firm.

Unfortunately on most occasions, silos encourage behaviours that are beneficial to the occupants of the silo, but are often not in the best interest of the overall business or its customers. It also plays into the hands of corporate politics, since silos help to keep things private. And we all know that in office politics information is power.
 A recent survey from the American Management Association showed that 83% of executives said that silos existed in their companies and that 97% think they have a negative effect. (Source)

I capture the idea of sabotage, or passing on external costs to other departments, in the table below. Here the company has two departments (each small table), and within each department there is a choice to cooperate on either project A, which provides that department with a payoff of 20, or project B, which provides a payoff to that department of 10. However, project A comes with an external cost to the other department of 15.

For each department it is better to cooperate on A, giving them 20 each, but also inflicting an external cost of 15 each. The overall company payoff is just 10 in this situation. However, if the departments each cooperate internally on B, the overall firm payoff is double, at 20, as there are no other externalised costs.

Thus, for large organisations, the emergence of silos that are blind to the situation of other parts of the company may end up with a choice of projects and investments that are not overall optimal and efficient. Companies that find ways to ensure they maintain this inter-departmental efficiency as they grow are those that the market will select for.

Notice that this problem is a much more serious one in governments where there is no government-level selection pressure. At best there is an occasional change of government in a democracy, but rarely does this provide strong incentives to change operational processes all that much.

Indeed, the incentive to sabotage other groups and inflict costs on them also arise with market competition in general, and as such, provides a strong basis for competition laws and intervention where negative externalities from the activities of certain firms exist.

Muir’s chickens
The lesson here about market competition acting as a selection mechanism to favour firms that have high within-group cooperation is radically displayed in the experiments of William Muir, who bred chickens and either selected for a) the most productive individual egg-laying chicken, or b) the most productive cage of egg-laying chickens (in each cage were 9 chickens).

The results drive home the message of group selection is a process that increases the number of cooperators and total efficiency.

The first method favored the nastiest hens who achieved their productivity by suppressing the productivity of other hens. After six generations, Muir had produced a nation of psychopaths, who plucked and murdered each other in their incessant attacks. No wonder egg productivity plummeted!
In the second approach, he selected the most productive groups and because they were already a group that worked well together, they included peaceful and cooperative hens. (Source)

Egg production by the cooperative cages increase 160% over just a few generations. More detail here.

How to stop corruption in town planning

I spoke this week at the Australian Public Sector Anti-Corruption Conference in Sydney about how to tackle corruption in councils and in town planning generally.

My main proposal is to not focus on political donations, disclosures, or electoral procedures, but instead to remove the economic payoffs available from being corrupt. In other words, remove the honeypot and you will get rid of the flies.

In town planning, the honeypot is the $11 billion worth of new property rights granted through the planning system to selected landowners across Australia each year.

If councils didn't have this power to make millionaires out of some landowners there would be no reason to lobby them in the first place. So why not simply charge the market price for new property rights made available through the planning scheme? No more honeypot. No more flies.

Below is the paper I discussed. What I didn't discuss in detail was a politically viable implementation. After all, some landholders have recently bought development sites and paid a price to the previous landholder that reflected their assumption that their planning application would be costless (or come with just a small administrative cost). That is, the previous landowner has already been paid for the new rights from the planning system that they were given for free.

To ensure that these recent purchasers do not pay twice for the same new property rights - once to the previous owner, then again to the council or state government - there can be a short phase-in period of a year or so where development applications made during that period operate under previous rules. This will bring forward a lot of development by landholders who have recently bought development sites since there is now a huge cost to delaying development and construction. Their chance to develop under previous rules is not taken away at all. The time frame is simply shortened.

So it is win-win all around. Charging for new property rights is economically efficient and captures pure economic rents. It removes the honeypot that political mates swarm around. And its introduction will increase housing supply by bringing forward development that would otherwise be delayed by private developers seeking to drip feed new developments into the market to maximise returns.

Get my full conference paper here.