Tax motivated takings.

Tax motivated takings are takings by a local government aimed purely at increasing its tax base. Such an action was justified by the Supreme Court's ruling in Kelo v. New London (2005), which allowed the use of eminent domain for private redevelopment projects that promise sufficient spillover benefits to the public in the form of taxes and jobs. Still, the question arises as to why, if the targeted land is more valuable for redevelopment than in its current use, the developer has to resort to eminent domain to acquire the land, thereby bypassing the market. There are two possible reasons. The first is the holdout problem, which says that individual owners will seek prices in excess of their true valuations in the knowledge that each one can potentially prevent the entire project from going forward. The holdout problem, which is a form of monopoly, plagues both public and private projects, and eminent domain is a legitimate response to this form of market failure.

The second reason that developers may seek the power of eminent domain for large scale projects is that owners' true valuations of their land will generally exceed the assessed values of the parcels. Thus, it is possible that the market value of the proposed redevelopment will exceed the aggregate assessed value of the targeted land, but will be less than the sum of the true valuations (its opportunity cost). When this is true, the project is inefficient, but the local government, acting in the interests of the majority of landowners in the jurisdiction, will nevertheless want it to go forward so as to enhance the local tax base. We refer to the use of eminent domain for this purpose as a "tax motivated taking."

After indentifying this problem, the paper proposes a reassessment scheme that discourages local governments from resorting to the use of eminent domain purely for tax reasons. Specifically, the scheme says that if a landowner turns down a legitimate offer from a developer to buy his or her property, the property will be reassessed at the amount of the often Under this scheme, the local government is indifferent between the sale's taking place and not taking place since its tax revenue will be the same either way, thus eliminating its incentive to force the sale. Moreover, the scheme results in only efficient sales occurring. The paper concludes by noting several practical difficulties with the scheme, especially in the case where there are multiple owners who differ in their unobserved valuations of land.

INTRODUCTION

The recent Supreme Court case of Kelo v. New London (125 S.Ct. 2655, 545 U.S. 469, 2005) approved the use of eminent domain by a municipality seeking to acquire land primarily aimed at economic redevelopment. The case tested the Constitutional requirement, stated in the Fifth Amendment, that eminent domain can only be used to obtain land for "public use." (1) The requirement is clearly satisfied--and the use of eminent domain is uncontroversial--in cases where the land is intended for a highway or park, but the issue becomes more difficult when, as in Kelo, the land is given to a developer for use in a private project. Although the resulting benefits are, therefore, largely private, there may nevertheless be substantial spillover benefits to the community, "including--but by no means limited to--new jobs and increased taxes" (Kelo v. New London, p. 2665). The Court argued that existence of these benefits, as part of a comprehensive redevelopment project, satisfies the public use requirement.

Kelo is not the first case to reach this conclusion. In Berman v. Parker (348 U.S. 26, 1954), the Supreme Court had previously argued that eminent domain could be used for a redevelopment project aimed at eliminating urban blight in Washington, D.C. Similarly, in Poletown Neighborhood Council v. City of Detroit (304 N.W.2d 455, 410 Mich. 616, 1981), the Michigan Supreme Court allowed the city to use eminent domain to condemn an entire neighborhood in order to clear the way for a new General Motors assembly plant. Again, the Court cited the economic benefits from the increased jobs and tax revenue as its justification.

Still, courts have not universally accepted the principle that "public use" includes private uses with some spillover public benefits. For example, in 2004, just a year before Kelo, the Michigan Supreme Court reversed its earlier decision in Poletown when it disallowed the use of eminent domain for a private development project, despite the fact that the project created 30,000 new jobs and promised $350 million in tax revenues for the county. (2) In reaching this conclusion, the Court emphasized the fundamental protection of private property afforded by the Constitution. Specifically, "if one's ownership of private property is forever subject to the government's determination that another private party would put one's land to better use, then the ownership of real property is perpetually threatened by the expansion plans of any large discount retailer, 'megastore,' or the like" (Wayne v. Hathcock, p. 786). Thus, although the Kelo decision represents the law of the land, there is not universal agreement regarding the proper scope of public use. Indeed, since the Kelo ruling, no fewer than 42 states have passed legislation imposing some limits on the use of eminent domain for purely private development. (3)

The purpose of this paper is not to engage in the broad debate about whether local governments ought to be allowed to exercise eminent domain in cases of private development, a topic that has been discussed in depth elsewhere. (4) Rather, it is to examine the implications of allowing local governments, in the wake of Kelo, to use eminent domain specifically for the purpose of enhancing their tax revenues by forcing the transfer of land to higher valued uses. We will refer to such uses of eminent domain as "tax motivated takings." Although this type of action is apparently justified by Kelo as a legitimate public purpose, we will argue that, if the objective of local governments is to increase tax revenues (as suggested in the Kelo decision), then allowing the use of eminent domain in such cases can lead to inefficient transfers of land. The simple reason is that assessed values generally understate true values. For example, a piece of property assessed at $10,000 for tax purposes may be worth, say, $25,000 to the owner in the sense that she would not sell for less than that amount in a consensual transaction. Thus, if a would-be buyer offered $20,000, the owner would refuse to sell. In contrast, the local government, acting in the interest of the majority of voters, would like the sale to occur because it would then be able to extract more taxes from the property. The temptation to use eminent domain in this situation is apparent. Indeed, it is one of the objections raised by the dissenting justices in Kelo: "[W]ithout a bright line rule preventing the use of eminent domain for private projects,] nothing would stop a city from transferring citizen A's property to citizen B for the sole reason that citizen B will put the property to a more productive use and thus pay more taxes..." (Kelo v. New London, pp. 2666-7).

At its root, the inefficiency that results from the allowance of eminent domain stems from the combination of two factors: the local government's desire to extract additional tax revenue, and its inability to observe the owner's true valuation. This second factor effectively exempts $15,000 of the owner's valuation (her so-called "subjective value") from taxation (which is why she has no incentive to reveal her true value). (5) Thus, the only way the government (responding to the first factor) can capture at least some of this value is through a sale of the land, whether consensual or forced.

The remainder of the paper describes this problem in more detail, focusing on the potential inefficiency arising from it. We develop a simple model to identify more explicitly the inefficiency that arises when tax-motivated local governments can use eminent domain in cases of private development. We then propose a reassessment scheme that could increase efficiency by discouraging local governments from resorting to eminent domain purely for tax reasons.

The paper is organized as follows. The second section discusses the concept of tax motivated takings and subjective value in more detail. The third section then presents a simple model of land transfers in the context of a project requiring a single parcel. The model is used to illustrate both the inefficiency that occurs when subjective value is not taxable, and the reassessment scheme we propose as a possible solution to this inefficiency. In the fourth section, the model is extended to the case of a project requiring purchase of multiple parcels. We show that the basic results from the single parcel case carry over to this case as well, provided landowners have identical subjective values. With identical landowners, our reassessment scheme both restores the efficiency of market transactions and eliminates the incentive for tax-motivated takings. However, in the more realistic case where subjective values differ (unobservably), the proposed scheme cannot fully restore the efficiency of market transactions, but it would still eliminate the local government's incentive to inefficiently exercise its eminent domain power simply for purposes of raising tax revenue. Finally, the fifth section concludes.

TAX MOTIVATED TAKINGS DEFINED

As noted, tax motivated takings are defined to be takings aimed purely at increasing the local tax base, as opposed to assembling land for public use. Thus, instead of being used for a park or highway, the acquired land is given to a private developer for use in a commercial project whose value exceeds the aggregate assessed values of the taken parcels. The project, thus, promises greater tax revenues that can be used to increase the provision of public services like education or police protection. In this sense, the taking can be construed as indirectly satisfying the public use requirement of the Fifth Amendment, even though the acquired land is not itself being used for the public good. (6) This is essentially the logic underlying Kelo and Poletown.

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