Taxing Away The High Cost Of Living

MS wants to know:

I have been thinking about your May 20 post $250,000 A Year In Fargo Doesn’t Buy You An Apartment… for a while. While I do not necessarily disagree with your conclusion, I have trouble fitting your argument into a coherent theoretical framework. In particular, I believe the standard case you advance for progressive taxation is declining marginal utility of consumption and/or wealth. I hope you would agree with me that the relevant utility function is defined in terms of real, not nominal, dollars when considering declining marginal utility of wealth.

I suspect that if the BLS constructed a Manhattan Price Index it would indicate that the price level of Manhattan goods and services is much higher than that of Fargo. Thus, for any given level of nominal income people in Manhattan have lower real income than people in Fargo. As a result, as long as you believe in CPI indexing tax rate cut offs, I don’t know why you wouldn’t believe in some form of cost of living indexing.

I think this is a kind of a mistake. The higher “cost of living” in Manhattan is composed overwhelmingly of two things. One is that the quality of services available in Fargo and Manhattan are not the same. Manhattan has better fine dining, Manhattan has better pizza, etc. The other is that land is Manhattan is much more expensive than land in Fargo. As we’ve seen, even small changes in distance from the Empire State Building are associated with steep declines in the price of land:


Since Manhattan land is so valuable, Manhattan is very dense. But there are still major restrictions on real estate developers’ ability to create additional density in Manhattan. You wouldn’t, for example, be allowed to knock down a gorgeous pre-war apartment on 5th Avenue and replace it with a 67 story modernist apartment tower no matter how strong the market demand for it might be. Consequently, the high price of Manhattan land feeds through into a high cost of Manhattan office space and a high cost of Manhattan housing. But there’s no reason Manhattanites should get a tax break relative to Fargoans for their own decision to make housing artificially scarce.

What’s more, the houses got so expensive because of all these Manhattanites bidding against each other. If there were higher taxes on high-income households, then the bidding over scarce Manhattan real estate would be less intense and the prices would be lower. And since the supply of Manhattan housing is driven primarily by regulatory issues and not by the prices, these lower prices wouldn’t reduce supply.