In the first part of this series, we discussed the problem of statewide efforts to “fix” problems in the complex, adaptive systems of cities. I suggested that statewide reform should not layer distortion on top of distortion, but should—in the spirit of Via Negativa—be geared toward fixing bad incentives created by state policy. Today’s article will discuss annexation as an area where this is possible, and statewide reform could address systemic issues that impact growing cities.

A Rigged Lottery

In 2015, Iowa police arrested Eddie Tipton on charges of fraud. As an employee of the Multi-State Lottery Association, he had access to the computers that generate the random numbers that determine lottery winners. Tipton, it turns out, had managed to rig the lottery to produce a winning ticket.

I thought of that story during a conversation with a friend who runs the planning department for a small city experiencing dizzying growth at the urban fringe of a major sunbelt metropolis. He mentioned upcoming plans to annex thousands of acres of rural land for new urban development. All I could think about was how a handful of land speculators were about to become filthy rich.

I’ve had conversations with another friend in another high-growth city who outlined the complicated schemes speculators employ to land bank agricultural land for future urban development. The process includes state tax breaks based on having a water well for irrigation purposes. The speculators make sure to water the property once a year from the well and patiently wait as the urban boundary creeps closer, bringing with it promises of a major payday.

Annexation: A Growing Concern

Annexation is the state-sanctioned process by which a city expands its territory. In a growing city, this is an important power that opens up new land for development. In all states I’m familiar with, the annexation process is defined by state law (and sometimes in the state constitution). Annexation can cover several different cases, such as one municipality taking over another, or a city incorporating farmland at the edge of town.

Land that is outside city limits is generally not eligible for city services such as sewer and water, which severely limits its development potential and thus, its monetary value. Empty land that is within city limits suddenly becomes extremely valuable as it can be developed at urban intensities. The difference in value between the two opens up a major arbitrage opportunity for speculators who seek to buy cheap land outside the city, get it annexed, and then either develop or sell at a massive profit.

In its current form, annexation of rural areas effectively functions as a rigged lottery: The occasional lucky landowner receives a massive windfall by virtue of owning or inheriting property in the right location, and the shrewd speculator realizes the expected profits from buying cheap rural land, waiting, and eventually applying for it to be annexed. And this is all spurred by government action that is important and necessary. If the Growth Ponzi Scheme represents the socialized losses of Lemon Socialism, annexations are the privatized gains.

This process can distort the incentives for cities too. At no cost, they can generate the next cash infusion to prop up the Ponzi scheme. All that new development will contribute to city revenue for years before the systems that support it will need major upgrades or replacing.

Piling On Solutions

Recognizing that willy-nilly annexation can lead to leapfrogging, as well as the speculative urge inherent in annexation, states have employed various tactics to curb bad behavior. Among them are impact fees, urban growth boundaries, and administrative review by state regulators.

“Instead of attacking the root cause, we have attempted to address bad behaviors...We have ‘given a solution’ without ‘getting to a system that produces a solution.’”

Recall that the impetus for this series was related to statewide zoning reform. Each attempt to address the abuses of annexation was the statewide urban growth reform of its time. In most cases they’re an improvement over the status quo. In all cases, they have failed to create stronger cities and towns. They have failed because they don’t address the systemic structures that make the bad outcomes profitable for individual actors.

Instead of attacking the root cause, we have attempted to address bad behaviors. To borrow language from the first post in this series, we have “given a solution” without “getting to a system that produces a solution”.

A Modest Proposal: Purchased Annexation

One simple adjustment would improve this system: require cities to own development rights for the rural land they annex. We will refer to this as “Purchased Annexation”. Under Purchased Annexation, the addition of new territory can happen at whatever pace seems appropriate to the city. No more complicated calculations of acreage needed for the next 20 years of development. No more state oversight of local annexation decisions.

Students of real estate law will recall that real estate ownership can be thought of as a bundle of sticks, each representing a right to use that land in various ways. If you own the entire bundle, you are said to own the land fee simple. But it’s possible to separate that bundle and sell off certain rights, one of which is the right to develop that land for urban uses. Farmers and rural landowners at the urban fringe would, of course, be free to continue to own their land as long as they desire. Should an owner choose to apply for annexation, the city would first have to purchase the stick in the bundle that allows for urban development.

The benefits to Purchased Annexation are four-fold:

Speculation of land at the urban fringe is eliminated.
Cities have to pay to expand their boundaries.
Lower tax increase on unwilling landowners.
Cities have a stronger say in new development.

Let’s explore how each of these works.

1. Neutering Land Speculation. The entire premise of land speculation at the urban fringe is that an entity buys inexpensive land that is not currently suitable for urban development because it’s not within city boundaries, waits until an appropriate moment to apply for annexation, and then reaps significant profits after annexation as the value of the land rockets upward. The character of the land hasn’t changed. Its location is consistent, its soil quality is constant, the slopes are the same, the drainage remains the same. The only variable that affects this massive change in value is the ability to take on urban development because of its inclusion in the city’s boundaries.

By forcing cities to buy development rights before rural land can be annexed, the speculative market is neutered. Profits from city boundary changes don’t accrue to private landowners because development rights have to be sold to the city as a precondition for annexation. It is now the city who buys cheap land and turns a profit, which is returned to the public, where it belongs. This is appropriate since public action has created the added value to begin with.

2. Paying for Expansion. Since urban development is generally not allowed in rural areas outside of municipal boundaries, the cost to purchase that stick from the bundle is relatively small. Remember, the city isn’t purchasing the land itself; it’s only purchasing the right to develop. But there’s still a cost to be paid. When cities have to pony up for expanding their boundaries, the nature of the conversation changes.

The problem of leapfrogging is reduced since it wouldn’t make sense for a city to spend money on a distant parcel without first securing adjoining land. Aggressive urban expansion without a market for new development is also bridled; cities won’t be inclined to pay for new land unless there are developers willing to buy the land back after annexation for development.

3. A Taxing Struggle. Even in high-growth cities, there can be unwilling participants in annexation, regardless of the financial benefit of being annexed. State laws generally impose constraints to minimize forced annexations. For residents who aren’t interested in selling their land to make way for new development, one of the primary objections is the increased tax burden from municipal taxes.

There may be no way to completely avoid this issue as municipal taxes tend to be higher than rural taxes, owing to the added services provided by municipal governments for things like parks and sewer service. Under Purchased Annexation, though, this effect is blunted because the taxable land value for the landowner does not include the rights of urban development, which are owned by the city. Without these development rights in the “bundle,” the owner’s taxable portion of the land value does not skyrocket post-annexation, and so the increase in taxes is reduced compared to fee simple ownership.

4. A Stronger Say in New Development. Over the course of the 20th Century, cities gradually ceded a few significant aspects of city development, most notably the master street plan. The history behind the neglect of this critical bit of municipal power is undoubtedly complex and one which I’m not terribly familiar with. Purchased Annexation offers one way to regain some leverage over the form and function of local streets. Since developers would need to purchase development rights from the city, the city is empowered to ensure new development meets criteria for street connectivity, land use mixture, and other elements of good urban form much more effectively than with current tools such as subdivision regulations.

Aligning Incentives

Purchased Annexation introduces a new revenue stream to the city: sale of development rights on newly-annexed land. Cash-strapped cities would doubtless be eager to put those funds to good use. It is important, however, to eliminate a related revenue stream that creates its own perverse incentives: impact fees. Impact fees are charges assessed for new development. Their ostensible function is to cover the external costs of new development: infrastructure and service upgrades on the city’s part that a new influx of population renders necessary. But the connections between development and cost are often ill-defined and impossible to quantify. And impact fees can create their own perverse incentives for cities to approve development they might otherwise balk at.

Replacing impact fees with proceeds from the sale of development rights would have varying financial impact depending on the impact fees and development market of a city. It undoubtedly reduces costs to developers, who, in a competitive market, will pass most of those savings along to buyers. Fundamentally, it redirects money that previously rewarded rent-seeking behavior from speculators into activity that results in public goods.

Respecting Complexity

“Here’s a rule of thumb: the more complicated a set of regulations, the more likely it is to be ‘giving a solution’ rather than ‘getting us to a system that produces a solution.’ ”

Here’s a helpful rule of thumb: the more complicated a set of regulations, the more likely it is to be “giving a solution” rather than “getting us to a system that produces a solution”. This is the difference between “simplifying” and “tinkering”. The US Tax Code is a poster child for the counterproductive approach of “giving solutions,” piling on layer after layer of complexity in the process. Every provision is the result of some legislator’s pet issue, or a major donor’s desired loophole. The most impactful and robust forms of legislation are elegant, simple, and concise; The First Amendment to the US Constitution is a mere 45 words, for instance.

Purchased Annexation meets this test. It is concise, unambiguous, and universal. It replaces or at least strengthens complicated programs and fees with a simple requirement. It tweaks an important function of city government to eliminate bad incentives by attacking their root cause rather than attacking bad behavior. In short, this reform gets us closer to a system that produces a solution.

Read all of Spencer Gardner’s series on state-level reform:

Part One: When should the state jump in to address local problems?
Part Two: The Annexation Lottery
Part Three: Land Use and Services: A More Perfect Union