When one looks at fiscally distressed cities, it is easy to conclude that insolvency is simply a product of ineffective management, a lack of financial discipline, or the incompetence or corruption of local government. However, several important countervailing facts are worth considering: fiscal insolvency of municipalities today is often the artifact of bad planning decisions made decades ago; many events that led to local fiscal insolvency, including bad planning decisions, were beyond the control of municipalities; and the delicate dance of matching irregular revenues against unpredictable expenditures challenges even the best-run municipalities.

Many planning decisions that catalyzed the decline of Detroit and other Rust Belt cities were made at higher levels of government. For example, construction of federal interstate highways in the 1950s often ran slipshod over local plans and preferences and greased the skids of urban exodus for families, enterprises, and wealth—motivated by the tax advantages of jumping municipal borders. The city of Detroit lost some 60 percent of its population and much of its industry and commerce between 1950 and 2000, while the population of the metropolitan area remained fairly stable. Tax bases and populations of nearby municipalities grew substantially while Detroit’s evaporated during that half-century.

Similarly, policies at state and federal levels imposed unpredictable and often unmanageable spending requirements on local governments. Over decades, localities were buffeted by revisions in revenue-sharing formulae of higher-level governments or unfunded mandates. The Clean Water Act, for example, established a much-needed regulatory framework that has cleaned up waterways and protected citizen health since 1972. It also imposed draconian financial demands on local governments, saddling them with the costs of expensive water systems upgrades to meet ever more stringent standards, and the seemingly impossible challenge of separating storm water and wastewater in commingled underground systems built a century ago.

As municipalities internalize the message that poor financial performance is a local problem, they often take remedial actions that inflict more serious damage on their economic and social futures. One of the underreported aspects of the unfolding tragedy in Ferguson, Missouri, is the extent to which the violence and recrimination there is rooted in fiscal challenges. Ferguson, like many jurisdictions in St. Louis County, chose to supplement insufficient local revenues with traffic fines that were harshly enforced. Many similar jurisdictions derived 30 percent or more of their general revenues from enforcement of traffic violations. It is best left to the courts and the Justice Department to determine whether the pattern and practice of enforcement in Ferguson was discriminatory. But there is a separate issue involving the conflation of public safety and revenue generation, which can lead to perverse outcomes.

St. Louis County is not unique in its creative use of local courts as a revenue generator; it is pattern and practice in municipalities across the United States and other continents. In a 2006 study of North Carolina counties by the St. Louis Federal Reserve Bank, humorously named Red Ink in the Rear View, the authors found that a 10 percent decrease in annual revenues led to a 6.4 percent increase in traffic citations. Interestingly, there was no reversion to fewer citations when revenues rose. In one astounding case, the town of Waldo, Florida, derived half of its general revenues from traffic fines. New York City netted $624 million in general revenues in 2008 using aggressively priced and enforced parking violations. On the international front, the BBC and The Guardian accused London’s Hammersmith and Fulham Council of using traffic courts as a major revenue source in 2013.

Another dangerous way that municipalities shore up finances is through the sale of tax liens to investors. Although this practice attracts needed revenue, conveying powerful tax liens leads to unintended consequences that are difficult to manage. The dominance of tax liens over all other liens gives extraordinary power to those exercising foreclosure. Savvy investors who pay a small share of outstanding arrearages to purchase liens can acquire properties at pennies on the dollar of actual value. These new owners manage their holdings to maximize return, which often runs counter to public interest when it promotes naked speculation on vacated properties or accelerated neighborhood decline through widespread absentee ownership.

Municipalities make desperate choices like these to improve fiscal status in part because of popular opposition to property taxes, the dominant source of local revenue. Any municipality that considers raising property taxes to cover obligations faces the prospect of local tax revolts or increased pressure to relieve residents and businesses of tax burdens. In this issue, Adam Langley analyzes the property tax credits and homestead exemptions that provide individual relief from this unpopular tax, but further constrict local public budgets (p. 24). Constraints imposed by property tax limitations often lead to more reckless measures to make ends meet.

Perhaps there are other approaches available to municipalities to restore fiscal health. In Detroit, an unprecedented partnership among the public, private, and civic sectors supported a participatory planning exercise called Detroit Future City. More than 100,000 residents contributed to the design of this extraordinary land use and economic redevelopment strategy. John Gallagher reports on early implementation of projects that are intended to bring this community vision to reality in the Motor City and turn around decades of decline (p. 14).

Municipalities in developing countries confront a different set of fiscal challenges. In many countries, as national governments devolve responsibility for supplying public goods and services to localities, municipalities must invent new local public finance systems; most see property taxation as a promising revenue option. However, effective property tax systems are built on foundations such as land registries and value assessment tools. The difficulty of building these systems is magnified in cities with expansive informal settlements, where residents and their homesteads are not officially registered or recognized. Ryan Dubé reports on some of the challenges of establishing and maintaining a property registration system in Lima, Peru, where an upgraded system has not delivered on hypothetical benefits proposed by theorists (p. 6).

The challenges of attaining and sustaining municipal fiscal health are manifold and complex but not insuperable. During the 1960s and 1970s, today’s hottest American urban economies also struggled with population flight, urban blight, and insurmountable fiscal challenges: the cities in or near bankruptcy then were Boston; New York; Washington, DC; Seattle; and San Francisco. Their renaissance might have had less to do with their intrinsic greatness than the work of larger forces at higher levels of geography. This is not to cast aspersions on our great coastal cities; it is simply to make the larger point that municipal insolvency is a structural problem, not necessarily a product of any particular deficiency in local leadership.

Sound planning and effective public management lay at the heart of municipal fiscal health. A sound fiscal stance is required to finance public investment in projects that build a prosperous and sustainable local economy. A robust local economy grows a tax base that throws off revenues, which local governments need to pay for the public goods and services that support a good quality of life. But chronic and unpredictable variability of both local revenues and expenditures requires effective planning to survive inevitable bumps in the road.

In October, I named redevelopment—the effective reuse of previously developed land—a millennial challenge. Managing and sustaining the fiscal health of local governments is another such challenge. We need a better understanding of the theory and practice of planning, taxation, and valuation that can guide municipalities’ efforts to pursue this elusive goal. The Lincoln Institute of Land Policy is uniquely poised to inform such efforts. In this issue, we’ve touched on a few topics that relate to municipal fiscal health; this millennial challenge will remain a major focus of our work here at the Institute.

“Being a migrant worker for 13 years, I have longed to own a home and live a normal family life here in Shenzhen,” said Mr. Wang, a former farmer from Sichuan Province who now earns 3,100 yuan (US$500) per month in the manufacturing sector of this sprawling city in South China. Wang recently purchased what is known as “small property rights” (SPR) housing—an illegal but widespread type of residential development built by villagers on their collectively owned land in peri-urban areas and urban villages, rural settlements surrounded by modern development in many Chinese cities. While no official statistics are available, the number of SPR units is estimated at 70 million—perhaps one-quarter of all housing units in urban China (Shen and Tu 2014). “Small property rights housing fulfills my need,” continued Mr. Wang. “It’s affordable. It is the best choice for me,” he says.

Sold primarily to individuals without local household registration, or hukou (box 1), SPR housing violates China’s Land Administration Law, which stipulates that only the state, represented by municipal governments, has the power to convert rural land into urban use. Unlike buyers of legally built homes, buyers of SPR housing do not receive a property rights certificate from the housing administration agency of the municipal government; they sign only a property purchase contract with the village committee. Because Chinese laymen often see the state as the “big” institution, housing units purchased from village committees are popularly called “small” property rights housing.

Box 1: China’s Hukou System

China is phasing out its household registration system called hukou, which dates to the 1950s. Hukou identifies a citizen as a resident of a particular locality and entitles the hukou holder to the social security, public schools, affordable housing, and other public services provided by their district, township, or village. Many urban public services are available only to urban hukou holders. Because most migrant workers hold rural hukou, they are ineligible for many public services in the cities where they work and live. Moreover, they have to return to their registered places of residence to apply for marriage certificates, passports, personal ID card renewals, and other documents—a requirement that comes at significant cost and inconvenience.

The widespread development of SPR housing raises a number of legal, political, social, and economic concerns that have prompted academic study and heated public policy debates (Shen and Tu 2014; Sun and Ho 2015). Why has SPR housing emerged in China where administrative control is generally considered tight? What drove the village committees to develop SPR housing in violation of the Land Administration Law? Do SPR housing buyers worry about their tenure security? Why has the government so far tolerated SPR housing ownership? To find answers, one has to look at a number of factors contributing to the rise of SPR housing, including China’s land management system, municipal finance, and public attitudes toward laws and regulations.

The Rise of Small Property Rights Housing

The pace of China’s urbanization is unprecedented. Between 1978 when economic reform began and 2014, the urban population more than quadrupled from 173 million to 749 million, with average annual growth of 16 million. In official counts, the urban population includes residents with hukou and, in recent years, migrants who stay in a city for more than six months. Amid such explosive growth, the government’s institutional capacity to manage urbanization has often lagged behind, at best barely responding to emerging issues.

“The informal development of SPR housing is regarded as an extra-legal practice and a type of spontaneous urbanization,” wrote Dr. Liu Shouying, a senior researcher with the Development Research Center of the State Council, in his newly published book, Land Issues in the Transitional China (Liu 2014).

“There is no law explicitly addressing the emerging issues of SPR housing,” said Peking University Professor Zhou Qiren, a well-known property rights scholar in China (Zhou 2014).

Legal and Economic Factors

Under China’s dual land management system, urban land is owned by the state, and rural land is collectively owned by the villages (figure 1). There is no private ownership. Only the state has the legal power to expropriate rural land and convert it to urban use. Villages have no land development rights. Compensation to villages for expropriated rural land is based on the land’s agricultural production value rather than its higher market value.

When the state expropriates rural land for urban use, it allocates it to residential and commercial uses through concessions to real estate developers, who pay a fee for land use rights. This system allows municipal governments to expropriate rural land for industrial and urban development at low costs, and to generate handsome revenues from land concessions.

The municipal governments’ ability to expand the urban land supply is heavily limited, however, by China’s strict farmland preservation requirements. Under this policy, 1.8 billion mu (equivalent to 1.2 million sq. km) of high-quality agricultural land nationwide must be reserved for food security. The Ministry of Land and Resources annually approves the amount of urban land for each city, and the municipal government then allocates this supply to various purposes, leaving a small fraction (usually around 30 percent) for residential development. Given the limited supply of residential land in the major cities, prices are bid up very high.

By contrast, most cities offer industrial land to manufacturing firms at very low and subsidized prices in order to compete for investment and employment. They expect these firms to yield jobs, economic growth, and tax revenues for the municipality, and then for those new jobs to generate increased demand for housing and services—in turn creating more jobs, economic growth, and tax revenues. As a result, the price for residential land is up to 15 times higher than the price of industrial land (figure 2).

Over the last few years, concession fees from commercial and residential land were typically as high as 40 to 60 percent of municipal tax revenues. With these revenues, municipal governments not only subsidize industrial land, but also fund public investment in infrastructure and other services. Because farmers’ compensation was only a tiny fraction of the value created from the state-monopolized development rights, they were keen to find ways to share in these revenues, setting the stage for SPR housing.

There are three types of rural land in China: one is used for agriculture, one is used for construction, and the third is unused. SPR housing units are usually built on rural construction land, which allows for villagers’ residential plots and public facilities. While strict enforcement of the national farmland preservation policy generally prevents conversion of agricultural land into construction land, villages are not explicitly prohibited from using construction land for village industries, restaurants, hotels, warehouses, rental plants, and rental housing. Indeed, property rental businesses have existed in rural areas for many years. For example, rural households living in urban villages and at the rapidly growing urban fringe have built multi-story housing on their residential plots and rented the units to migrant workers.

When urban housing prices started to soar in the mid-2000s, the villages saw opportunities to make handsome profits from building and selling homes. Each year from 2006 to 2014, house prices climbed about 20 percent in Beijing, 18 percent in Shanghai, 17 percent in Shenzhen, and 11 percent in Chengdu (PLC-HLCRE 2014). The rapidly rising prices of residential land drove part of these increases.

Demand for home ownership in China remains strong, thanks to the growing urban population, rising household incomes, high savings rates among urban households, and lack of alternative household investments. And SPR housing units are much less expensive than comparable formal housing units in the same location. Indeed, their prices are typically 40 percent to 60 percent cheaper, because villages do not pay land concession fees as the urban real estate developers do, and the administrative costs of providing SPR housing are also lower. Thus, SPR units became the rational housing choice for many migrant households, and even for some urban households with hukou in their city of residence.

Social and Cultural Factors

The village committees understood that building and selling SPR housing violated the Land Administration Law and the associated local land regulations, but the lure of profits drove them to test the legal limits. And once a few villages started selling SPR housing, others were quick to follow. The central government responded by issuing a series of administrative circulars calling for a halt, but took little action due to the lack of legally effective and socially acceptable measures to put an end to the practice.

Meanwhile, given the lack of legal protections, one might ask why SPR housing buyers do not opt for rental housing. The answer is that the rental market in urban China is poorly regulated, and contract enforcement is weak. Tenants often face the risk of unexpected rent hikes and premature termination of leases. In addition, participation in the affordable housing programs run by the municipal governments is not an option for most migrant workers because they do not have local urban hukou.

At the same time, Chinese households strongly prefer home ownership for a number of social and cultural reasons. Most households consider a stable home essential to their lives. As Dr. Sun Yet Sen (1866–1925) famously said: “Every household ought to have a home.” The Chinese word for “family” (jia) is literally the same as the word for “home,” both in written form and speech. Most Chinese think that an ideal home is a secure place for the family, and the most secure home is a self-owned one. One SPR housing buyer in Shenzhen said, “With my newly purchased SPR housing unit, I don’t have to worry about being forced out of the rented unit any more, and I could make my own place a real home.”

Because healthcare and educational opportunities are better in cities than in rural areas, many migrant workers purchase SPR housing units so that their families can take advantage of these services. And for young men, buying SPR housing units is a way to improve their chances in the highly competitive marriage market, where men outnumber women by 34 million, according to the National Bureau of Statistics. Moreover, herding behavior—where everyone wants to do what everyone else does—is a significant factor, and the housing purchases of some buyers heavily influence the purchase decisions of others.

As some newspaper interviews and Internet surveys reveal, buyers generally do not worry about being prosecuted for living in SPR housing. They do not believe that the government would attempt to enforce the law on millions of citizens. There is a popular saying in the Chinese legal enforcement tradition: fa bu ze zhong (the law does not punish everyone). If many people violate a law or a regulation in China, people often consider the law itself flawed.

Indeed, over the history of economic reform in China, there are celebrated cases in which mass violation of a law drove change, resulting in legalization of formerly prohibited activities. Based on this history, many SPR housing buyers expressed confidence that the government would not evict them from their homes. This confidence is evident from the fact that SPR housing owners often spend a substantial amount of their incomes, savings, or borrowed money on home improvements such as interior decoration and furnishings.

Many SPR housing owners feel that they are already a large enough group to defy any government actions that penalize them. Eviction is highly unlikely, given that the Chinese government’s top priority is maintaining social stability. One SPR housing owner in Beijing said, “I am sure that the government will not evict us from our homes. If it happens, where should we live? In front of the municipal hall?”

A Major Challenge to Government

Enforcing the law against SPR housing development on millions of households would indeed be politically unwise. Doing so would likely trigger social unrest—the last thing the government wants to see. However, amending the law is not easy, and for some time the central government seemed unable to come up with a land management system suitable for an urbanized China. Without a clear solution, the central government thus tended to tolerate SPR housing.

Local governments, however, were more uncomfortable with the growing numbers of SPR housing units because they reduced demand for government-supplied residential land and therefore revenues from land concessions. But again, the fear of social unrest left most local governments with nothing to do but repeat the central government’s rhetoric about its illegality. Government tolerance also reflects the fact that SPR housing developments afford shelter for many lower- and middle-income groups that the government and the market have been unable to provide. In the public debate, the argument for SPR housing is that it serves an important social function by housing the large number of migrant workers essential to China’s rapid urban economic growth.

Perhaps the bigger concern for government is the impacts of SPR housing development on real estate markets, municipal finance, and future urban forms. As it is, the formal urban housing market is already in over-supply. Additional provision of SPR housing units would further weaken formal market demand and increase bank credit risk. Moreover, China’s city planning efforts do not cover rural land outside designated planning areas. The spread of SPR housing in these areas would therefore lead to undesirable urban development patterns.

Recommended Reforms

In recognition of the root causes of SPR housing development, the Third Plenary Session of the Communist Party of China’s 18th Central Committee issued a document in November 2013 spelling out directions for a set of reforms directly related to land, hukou, and municipal finance.

On land: Integrate the urban and rural construction land markets. Allow the sale, leasing, and shareholding of rural, collectively owned construction land under the premise that it conforms to planning. . . . Reduce land expropriation that does not promote public welfare.

On hukou: Accelerate the reform of the hukou system to help farmers become urban residents. . . . Efforts should be made to make basic urban public services (such as affordable housing and the social safety net) available to all permanent residents in cities, including rural residents who have migrated to cities.

On municipal finance: Improve the taxation system and expand the local tax base by gradually raising the share of direct taxation (mainly the personal income tax and property tax). . . . Accelerate property tax legislation.

These reform efforts aim to dismantle the dual system of land management, allowing villages to share in the benefits of land development and raising the transaction costs of land expropriation. The hukou system will be phased out gradually, starting in the smaller cities. While detailed actions on these two reform fronts are now being worked out or tested in pilot programs, municipal finance reform remains a major concern. If the scope of land concessions is reduced and the hukou system is dismantled, cities will see significant reductions in land sales revenues and increases in public expenditures for providing services to migrant workers and their families.

While residential property taxes are expected to become a new source of municipal revenues, this change will not occur immediately. Indeed, the central government is currently drafting the property tax law, and it may be at least two years before its passage by the National People’s Congress. Since it will also take a few years for cities to establish assessment systems, residential property taxation will not support municipal budgets for some time. Nevertheless, there is hope that this new round of policy reform will properly address the critical issue of SPR housing.

Li Sun is a postdoctoral researcher at Delft University of Technology, Netherlands, and an affiliated researcher with Peking University–Lincoln Institute Center for Urban Development and Land Policy.

Zhi Liu is senior fellow and director of the Lincoln Institute’s China Program, as well as director of the Peking University–Lincoln Institute Center for Urban Development and Land Policy.

References

Liu, Shouying. 2014. Land Issues in the Transitional China. Beijing: China Development Press.

Liu, Zhi, and Jinke Wang. 2014. “An Analysis of China’s Urbanization, Land and Housing Problems.” In Annual Report on the Development of China’s New Urbanization, Li Wei, Song Min, and Shen Tiyan, eds. Beijing: Social Sciences Academic Press (China).

PLC-HLCRE. 2014. “Report on the China Quality-Controlled Urban Housing Price Indices (CQCHPI).” Beijing: Peking University–Lincoln Institute Center for Urban Development and Land Policy (PLC) and Hang Lung Center for Real Estate (HLCRE), Tsinghua University.

Shen, Xiaofang, and Fan Tu. 2014. “Dealing with ‘Small Property Rights’ in China’s Land Market Development: What Can China Learn from Its Past Reforms and the World Experience?” Working paper. Cambridge, Massachusetts: Lincoln Institute of Land Policy.

Sun, Li, and Peter Ho. 2015. “An Emerging Phenomenon of Informal Settlement in China: Small Property Rights Housing in Urban Villages and Peri-urban Areas.” Paper presented at the Annual World Bank Conference on Land and Poverty (March 23–27).

Zhou, Qiren. 2014. “The Reform Should Not Be Self-limited” (in Chinese). http://heschina.org/archives/3211.html