A Good Tax

Gina Bellafante, who is usually an acute and sensitive observer of New York’s community life, wrote a somewhat misdirected column about the city’s retailing environment for Sunday’s Times.

The column portrays sympathetically several long-time Manhattan retailers who have been forced to close shop, or might soon, because of the high cost of rental space.  And they are sympathetic! However, the column identifies the City’s Commercial Rent Tax (CRT) as a contributor to the rent inflation retailers have faced and hence to the corporate homogenization of the city’s streetscape. There are several problems with this premise, not the least of which is that the CRT probably doesn’t contribute much, if at all, to the high rents for retail space.

The CRT, initially imposed in 1963 and modified a number of times since, effectively imposes a tax of 3.9% on commercial rent payments that exceed $300,000 annually.  The tax applies only in Manhattan below 96th Street and phases in beginning at the $250,000 benchmark.  The tax raised $816 million in the City’s 2017 fiscal year which, somewhat astonishingly, represented only about 1.5% of its tax revenue.

A savvy newcomer might ask why levy this tax at all, doesn’t it do more or less what a conventional property tax on commercial buildings does? The answer is yes, it does, but its origins and continued usefulness lies in New York State’s constitutional limit on how much property tax revenue municipalities in the state can raise.  In New York City’s case, that limit is 2.5% of the 5-year average of the full value of real property within it (with some complicated adjustments). The City has periodically bumped against that cap, so having a revenue source that is similar to a property tax, but which is not subject to the cap, is fiscally useful.

One of the problems with Bellafante’s column is the context. Writing in an anecdotal mode, the impression is created that retailing in Manhattan is under great stress from high rents, corporatization and e-commerce. Without minimizing those issues, the objective data doesn’t justify the impression that retail in Manhattan is withering. For example, Okada & Company presents data sourced to CoStar, which shows the overall Manhattan retail vacancy rate rising from a low of 2.5% in 2012 to 4.2% in 1Q2017, an increase but not a wipeout. At the same time, the City’s own property tax rolls show an increase in overall retail supply, with the gross square footage of “store buildings” in Manhattan increasing from 41 msf in 2013 to 47 msf in 2016 (driven by a huge increase in retail condominium space).  Most convincingly, the Census Bureau’s County Business Patterns shows the number of retail trade, drinking places and food service establishments in Manhattan growing from 19,762 in 2005 to 20,342 in 2015.  Granted, there are definitional and coverage issues with each of those sources, but taken together they do not suggest that the borough’s retail sector is in deep trouble.

In fairness, Bellafante’s focus is on the independent retailer and restaurateur, and although data on that issue is hard to come by, I share her concern that the corporatization and homogenization of urban space is something to lament.  I’m just not sure that it’s the real estate market that is driving that, rather than vice versa.

In any case, Bellafante gives voice to the retailers’ belief that the City’s CRT contributes to the plight of the city’s independent retailers and restaurateurs.  In that regard, I think they are all wrong. Although under the City’s law the lessee is liable for the rent tax, urban land theory suggests that the actual burden of the tax falls primarily on the property owner. If a retailer is willing and able to pay $478 per square foot in, say, SoHo, plus a 3.9% CRT bringing the total to about $497, they would presumably be willing to pay $497 in rent without a CRT. If the CRT were removed, the interest of landlords to extract as much rent as possible, along with competition among retailers to obtain the best locations possible, would bring the market rent back up to $497.  Although the lessee writes the tax check to the City, the tax is actually paid by the landlord through foregone rental income.

In a market like real estate where a certain amount of product is held as speculative inventory (vacant space), a tax like the CRT may have some marginal effect on the amount of space available. Since the tax drives a wedge between the amount of “rent” a retailer pays and the amount of rent the landlord receives, certain spaces may be kept vacant even though a retailer, in the absence of the tax, would be willing to pay the landlord’s reservation rent. But that effect is likely to have only a small impact on the overall amount of space offered or on the average market rent.

From the point of view of the City’s overall tax strategy, however, the CRT makes a lot of sense. The City, as it should be, is always wary of taxes that may encourage businesses to leave for other locations. When assessing its corporate income taxes, for example, it must judge at what point the corporate tax burden will outweigh the locational benefits of being in the city at all.  In that sense the CRT is a relatively harmless tax, since the burden of the tax falls primarily on property owners who can’t move their “locations” out of town. In fact, that is especially true for retail space, since the activity by its nature is local, and both retail tenants and landlords receive crucial benefits from City services like police protection, transportation and urban beautification.

Although the CRT was portrayed in Bellafante’s column as a burden on small retailers, the column was not an assault on the tax in general. Rather, it offered tacit support for a City Council bill that would raise the rent threshold at which a commercial tenant must pay the tax.  To the degree that independent retailers and restaurateurs disproportionately lease smaller spaces, raising the threshold could give them some competitive advantage relative to regional and national chains. That wouldn’t be such a bad thing and it would probably have a tiny effect on overall CRT tax revenue.