How to capture land value rises

We lack effective methods of capturing land value increases created by planning permission and public investment, says Paul Cheshire. But there are potential solutions.

In England, when the value of a particular piece of land increases, it is usually assumed to be a private gain of little benefit to anyone other than the landowner.

But rises in land value come about because of increases, or expected increases, in its productivity and this will often bring benefits to the whole community. Work to drain land or reduce flooding increases its productivity. So does decontaminating old industrial land, or building a new transport link that makes land more accessible.

The trigger for the rise in the productivity of a piece of land always involves investment. This investment may be in buildings on the land, or investment somewhere else that makes the land more useful.

Some of types of investment in land do not deliver the value uplift to the investor, and some do. This distinction is important. A good illustration of the first type is when the government makes a tract of land more accessible by building a new road or railway line. This means the productivity of all the affected land increases. As a result its price increases. But unless whoever invests in the better transport also owns the land, the people paying the costs do not reap the benefits.

The second type of investment that makes land more valuable goes into buildings as land is developed. This, too, makes the land more productive, but the extra value is fully captured by the person paying for the investment - the developer or owner.

But, in England, the great majority of the increase in the value of land following its development (or the granting of planning consent for its development) does not reflect any of these types of investment. Indeed, it does not represent investment in a useful sense at all. Instead it simply reflects the local relaxation of a planning policy-imposed supply restriction, which for two generations has released too little land for development. At the extreme, if farmland in say Barnet in north London was given planning permission with no associated obligations, the price would rise from maybe £20,000 per ha to £15 - £18 million per ha. We habitually call leaps in value such as this "planning gain". But it is not a product of investment in improving land. It is just the result of relaxing the scarcity our planning system has imposed in the first place.

These different sources of land value uplift create a varied mix of social and private benefits, incentives and assets. Understanding this, and the extent to which the different sources contribute to the productivity of the wider economy and welfare of society at large, is a prerequisite for developing practical policies to promote increased land productivity and capture the rises in value in a sensible way. Such policies are needed both to pay for the investment which improves the productivity and so the value of land, but also to ensure the wider community shares equitably in the gains which flow from developing land.

Land values and funding investment

There are therefore three quite distinct issues. Firstly, how to capture the uplift in land values caused by new investment making that land more productive but undertaken by a party that does not own the land, so does not directly benefit. That 'person' historically has most often been government. Secondly, how to fund complementary investment necessary when land is developed to improve the capacity of existing infrastructure for those who are affected (by their roads, schools or journeys to work becoming more congested, for example). Thirdly, how can we use the big "value uplift" generated by granting planning permission to fund things the community needs and/or to address the unfairness implicit in the windfall gains to the lucky land owner(s)?

At present the only 'land value capture' mechanisms we have are a mix of section 106 agreements (s106) and the Community Infrastructure Levy (CIL). For reasons I explain below, this is a woefully inefficient blend. At best, together these might partially address the second and third issues; CIL, for example, can be used to pay for more local infrastructure when development congests the existing supply; s106s provide some 'affordable housing', with the intention of using some of the value uplift generated by the permission to help poorer people. But neither helps with the first issue at all. This is a serious omission which causes significant damage to the whole economy. Indeed, last week's housing white paper promised that the government will explore the options for reforming developer contributions and make an announcement on them in the Autumn Budget (see News Analysis, p6).

Several attempts have been made in England to finance public investment needed to make land more productive by capturing the value uplift that the investment creates through a betterment levy. The levy was based on the argument that, if society spends resources improving land productivity, it is only fair that the landowners who gain should contribute to the costs of the investment.

The problem is that repeated attempts to impose betterment levies have shown they cannot work. We have tried to impose them three times since 1947; and on each occasion they have been repealed. The most important reason they fail is because they require a legally valid valuation both 'before' and 'after' the development, so each case is subject to challenge and the value uplift is mostly consumed in professional fees.

So if we cannot, and should not, impose betterment levies, we are left with two possibilities for capturing land value uplift caused by investment by non-landowners. As long advocated by economists, we could impose a general tax on land value. This would mean that, when land becomes more productive, and its value rises, so owners would pay more tax. A problem here is that governments have always proved reluctant to dedicate any tax revenue to particular purposes, so instead of funding productive investment, a land tax would likely just get lost in general revenues. However a land tax still has many attractions; it would improve the efficiency with which land is used, and probably the equity of how the benefit of land value uplifts are shared as well. The second possibility is a Development Land Charge (DLC), discussed below.

To tackle the second issue, of how to expand infrastructure and the capacity of public services for existing communities who experience more congestion because of new development, we have only the woefully flawed CIL. In part, this explains why in Britain new development tends to get such a hostile reception - our NIMBYism in other words. In the US, however, they do have a carefully tailored mechanism which many communities have adopted. These are Impact Fees.

The logic of these rests on the idea of community impact: that is the deterioration in the quality of services provided by existing infrastructure that new private development entails.

The US has a legal framework that allows communities to apply Impact Fees to finance additional infrastructure necessary to offset any deterioration in service quality for existing residents that new development might impose. Unlike CIL, any Impact Fee charged has to meet a 'rational nexus' test: that is to be legally valid, local government has to be able to show a clear connection between the development and the need for additional infrastructure, and the level of fees has to be explicitly related to these costs. CIL-charging local authorities have to show that the infrastructure for which they are seeking contributions is needed to support the building envisaged in the development plan. But they don't need to demonstrate any relationship between the fee they charge a particular development type, and the cost of the infrastructure it necessitates.

In addition the legal framework for Impact Fees requires that the necessary infrastructure justifying them must be provided, whereas there is no legal recourse for a payer of CIL who does not see the infrastructure that the levy was supposed to finance being built. In the world of impact fees, infrastructure is broadly defined to include not just transport and utilities, but local public services such as education, health or policing.

There are two other positive features of Impact Fees. The first, shared by CIL, is that although initially paid by developers, they are ultimately paid by landowners. Developers effectively subtract the calculated Impact Fee from the price they pay for land. The second, which is not shared by CIL or s106, is that where Impact Fees have been adopted, there is less resistance to new development.

In Britain we do not distinguish between or deal effectively with, either capture of land value uplift caused by investment by non-landowners or funding infrastructure improvements needed to absorb increased pressure created by the scheme. We have a mix of ineffective policies - ad hoc one-offs such as the CrossRail Business Rate Supplement, or s106 and CIL. These can - ineffectively - be applied to both issues. But s106s cause a long term problem. Since developers do not know what their s106 obligations will be in advance, they have to guess. This adds uncertainty to the already risky business of development. More risk means a higher risk premium, making less development viable. S106s also entail substantial transactions costs, so only more efficient local authorities ever charge them and they are only really worth charging on bigger developments. The extra transactions costs and the risk they impose on development mean they likely end up making housing less affordable, since they have the effect of reducing house building, and so cumulatively they restrict the supply of housing over time. They should have been abolished when CIL was introduced.

CIL itself is a kind of mongrel orphan - neither a betterment levy nor an impact fee. Although it has the advantage that a developer knows what the cost will be ahead of time, so it does not impose additional risk, the charge for each different type of development is set at the whim of the LA, and is not related to the actual community costs imposed by that type of development in that particular location. Nor is there any enforcement of the guidance that the revenues raised should be used to provide the supporting infrastructure needed. This is in the guidance, but vaguely framed and not enforced.

A new mechanism

There is another mechanism that could effectively address all three of the issues identified in relation to land development: a Development Land Charge (DLC) Compared even to Impact Fees, a DLC would be simple, predictable and transparent. It could also raise additional funds for infrastructure to improve new land, for social housing and a better resourced planning system. The idea would be to charge developers a straight percentage on the price of their finished development; or, if they did not sell or sold below market price, at an assessed market price. A rough estimate suggests a tax of 20 per cent would bring in far more revenue than the combined value of s106 and CIL, without the negative effect on the supply of development caused by s106's unpredictability and CIL's arbitrary rates. So the charge would be simple, not open to costly challenge and supply real resources for local government and public agencies investing in infrastructure. In addition, like an Impact Fee, it would be 100 per cent capitalised into the price of the land, so the ultimate cost would be paid by the landowner. Moreover if the experience of Impact Fees in the US is a guide, by compensating the local community for the cost of development, it would reduce the strength of NIMBYism.

The DLC would be applied to all types of new building - housing and commercial. Revenues raised would have to be spent, and there should be legal enforcement of this, on four activities only: 1) Investment in any type of infrastructure to support the additional development (including roads and other transport, health, education and training related investment, strategic utilities infrastructure, recreational facilities and areas; 2) Affordable housing; 3) The local authority's costs of running the planning system; 4) Cleansing or re-claiming contaminated land. The costs of providing the supporting infrastructure, however, should have the first claim on the revenue.

There is a serious problem in Britain with building enough homes and with funding infrastructure. Our present mechanisms for capturing land value uplift or using land values to fund any infrastructure at all are seriously flawed. Because we have been building so few homes, there is a crisis of housing affordability, but the only mechanism to fund affordable housing from land value uplift - s106 - has been found to be ineffective and in aggregate quite likely contributes to making housing less affordable. The proposed DLC would cover all the purposes served by Impact Fees, s106, CIL and a betterment levy together, but in a transparent, simple and cheap to apply form. It would be equitable because not only could the proceeds be used to fund affordable housing directly but it would be paid by the owners of the land that was developed.

Paul Cheshire CBE is emeritus professor of economic geography at the London School of Economics

The author would like to thank Arthur C. Nelson, Ph.D., FAICP for his help with his great knowledge and experience of Impact Fees.

Impact Fees in action

Albuquerque, New Mexico

In July 2005, the city charged builders of new commercial and residential buildings Impact Fees representing a 'fair, proportionate share' of the cost of the parks, roads, drainage facilities and public safety facilities necessary to serve that new development. For the same size of residential unit, Impact Fees in the rapidly growing suburban fringe where new and expanded facilities were needed were roughly ten times higher than those for infill and redevelopment locations where facilities already existed.

Gallatin County, Montana

Introduced Impact Fees in 1996. As the website of the local government of its main town, Bozeman, puts it: "Stable and robust infrastructure is one of the best incentives the city can offer to developers and home owners. Impact Fees are a one-time fee used to increase the capacity of water, sewer, fire and transportation systems to meet the needs of new or expanding development". Calculated public safety Impact Fees were about ten times higher in sprawling new development in the unincorporated county than in the city of Bozeman itself.

The US Department of Housing and Urban Development publishes a handbook: Impact Fees & Housing Affordability: A Guide for Practitioners. It includes numerous examples.