Largest Cities: The Shocks of Remote Work and Inflation, the Importance of a Return to Industry

NEW – June 12, 2022

This is referring to the largest metropolitan cities: New York, London, Moscow and others. For many decades, such cities attracted the wealthiest and most active people, and high prices were the most important feature of life. Developers, retail, bankers, and the state earned money on this high cost.

Now remote work and changing the place of residence of highly paid employees, e-commerce and delivery services, the high cost of fuel, transport and utilities are changing the economy of major cities.

With less serious transformations, New York in the mid-1970s and California in the early and late 2000s were on the verge of bankruptcy. Agglomerations of San Francisco, Seoul, Milan, and a number of large German cities limit the areas of trade and services, and successfully combine them with science and industry.

Moscow has time to transform its economy, but it needs to change its strategy to strengthen its leadership potential.

Large metropolitan cities as the focus of the income gap

According to statistics, for a typical country 50% of consumption comes from 10% of the population, and the remaining 90% accounts for the second half of consumption. In the largest cities, many times more affluent people live and work than in medium and small cities.

Capital cities host the headquarters of the largest corporations with the highest salaries and taxes. It is the consumption of the capital’s middle class that is most taxed. The tax security of capitals per capita is several times higher than in typical regions, as is the contribution of taxes from the activities of large cities to federal budgets.

Property taxes in the largest cities are high due to the high cost of the property itself and the progressive rates of these taxes. Durable goods are more expensive in the shopping centers of large cities than in the markets of small towns, and the wealthy population pays large amounts of VAT and customs duties on these goods, rent and commercial property tax. Residents of large cities spend several hours driving cars every day, and the tax component in the price of expensive cars and especially gasoline reaches 50-65%.

Approximately half of bank loans are related to real estate in the largest cities, if to count by the amount of money, and not by the number of loans. The concentration of affluent employees, consumers and investors ensures high prices of square meters. The high cost of residential and commercial real estate in the largest cities determines large amounts of loans for their purchase.

Nevertheless, many residents of the largest cities survive, formally receiving a decent salary, but also spending decently in the conditions of high cost of these cities. The majority of the poor in rich cities work in the service sector (trade, catering, transport, entertainment), serving the consumption of the rich. The service sector is characterised by low labour productivity and therefore low incomes.

In the second half of the 20th century, industry and science with high added value and labour productivity were concentrated in the largest cities. Even if production was characterised by a high share of manual labour, the long-term nature of the use of industrial goods (compared to one-time consumption of services) ensured their high utility and price, and a more decent standard of living for workers.

Moving production out of the largest cities to smaller cities and Asian countries has caused the descendants of workers to reorient themselves to the service sector. It is the rich who have become the main beneficiaries of decommissioning production, reducing costs and increasing profits, with the concentration of this wealth in the largest cities. The fallen and still relatively acceptable level of income in the service sector of the largest cities was provided by servicing the consumption of the rich.

The concentration of wealth and rising real estate prices were becoming a self-perpetuating phenomenon. More and more young people wanted to take advantage of the seemingly wide opportunities of the largest cities, and more and more wealthy people bought real estate in such cities. The success stories of previous generations became models for the next generations, and so the population and price levels grew in the largest cities.

Pre- and post-COVID challenges for major cities

Even before COVID, major cities were struggling with their own structural problems. The huge size of cities and transport difficulties negated the benefits of a broad labour market, sucking people’s time and money out of their budgets. Real estate became prohibitively expensive for the vast majority of those born in the largest cities and who “moved in” in the hope of achieving success. Overheated real estate prices did not give a proper return on investment, and the highest taxes ate up the few income from owning this property.

Major corporations were moving parts of their headquarters out of these cities, helped by advances in electronic technologies for remote office work that were evident even before COVID. The main motive for this was to save on salaries and offices that are very overheated in the largest cities. This most massively affected customer call centres, then accounting and tax management, and partly experimental design developments. A number of companies generally reduced their headquarters in the largest cities to the level of representative offices.

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The largest cities were faced with falling tax revenues and spread them out on the remaining ones. Most clearly, the re-registration of the largest corporations affected the income of taxes from such corporations. The reduction and relocation of highly paid employees slowed down the dynamics of retail sales and services. Growth in rental prices for residential and commercial properties was slowed down relative to price increases in other cities where headquarters and employees were moving. To make up for the loss of income, the authorities of the largest cities raised property taxes and began to save on social services, increasing the high cost of living and reducing its quality.

The retail and service economy was falling into the high-cost-of-living trap. The middle class of the largest cities was forced to increase spending on taxes and payable social services. Quality medicine and education have become associated with private clinics and schools. Owners of commercial real estate also increased taxes, more expensive life required an increase in the salaries of ordinary employees of trade and services. Rising costs were passed on to the price of goods and services, making them more expensive and reducing the number of purchases.

E-commerce and delivery services were relatively widespread even before COVID, and COVID only gave them a powerful boost. A few decades ago, people went to the largest cities for shopping, which ensured an increased turnover and a boom in shopping centres. Now almost every small town has online order collection points where it’s possible to get the widest range at affordable prices, which makes frequent trips to the capital’s shopping centres unnecessary. Maybe just look at it and try it on, then order it with delivery.

Some politicians in Western Europe, even before COVID, began to promote the idea of reducing excess imports of goods and energy carriers. Europe is experiencing a significant ageing of the population, making it difficult to maintain the same level of consumption. It also overlaps with a chronic budget deficit and massive public debt. The most famous place for expressing such ideas was the Davos Economic Forum, and the most famous ideas are “sharing economy”, “local economy” and “extending the useful life of products”.

Restrictions during the first and partly subsequent waves of COVID at least coincided with these trends. It was high-paid office workers who were first of all sent off for remote work, and many of them left for cheaper cities for months. It is the retail, catering and service sectors with a focus on expensive excess consumption that have been massively closed, especially in the largest cities. The cost of renting apartments, offices and shops fell by 1.5-2 times and recovered weakly when anti-COVID restrictions were lifted, even despite open inflation.

A little history and statistics of real estate prices

While real estate in the largest cities is still perceived as an anti-inflationary asset and is growing in price on concerns about the safety of the purchasing power of money. However, a surge in inflation will not be able to maintain the attractiveness of real estate for many years. High inflation reduces the population’s ability to buy expensive goods, as more money is spent on food and utilities. The need to raise interest rates on deposits and loans will further reduce the possibility of expensive purchases on credit, since the interest on the loan will be unaffordable.

History does not yet know the transformation of the real estate markets of the largest cities, but it does know the fall of individual leaders and massive temporary falls. The Italian Rimini or English Brighton were the most prestigious and expensive small towns of the 1970s, like Rublyovka near Moscow, but then they ceded way to other cities. Detroit and Las Vegas are famous American examples of the irretrievable decline of previously very rich cities. In 2009, the top ten most expensive cities in the United States lost up to half the market value of real estate, with a full recovery only by 2016.

New York City residential property prices fell by a quarter from their peak in May 2006 to 2012, only returning to their previous peak in October 2020. During the inflationary surge of the last year and a half, prices in New York increased by 19%, but a third slower than the American average. Property taxes in New York, levied in the range of 2 to 6% of the market value, make investments in real estate for 15 years unprofitable by minus 11% (even at the minimum tax rate and taking into account the surge in inflation).

In London, residential property prices stood from 2017 to 2020, falling slightly at the first lockdown, then adding only 9% on the inflationary surge. A typical London home is taxed on a progressive scale at an average rate of 5% (with tax deductions only for poor locals), making the return on investment in this property over five years minus 16%. Prices for British real estate excluding London increased 5% from 2017 to the first lockdown, then for the inflationary jump of the last year and a half another 20%, beating London prices by 2.5 times.

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Moscow is not the leader among Russian major cities in terms of residential property price growth. Housing prices in the first quarter of 2022 in relation to prices in the first quarter of 2020 in the 25 most expensive Russian cities increased by an average of 53%, while prices in Moscow increased by 28%, and according to this indicator, Moscow took the penultimate place among these 25 cities. At the same time, the average price per square meter in Moscow was 251,000 rubles, and in the other 24 most expensive cities an average of 97,000 rubles, that is, a 2.5-fold gap. So expensive Moscow is forced to become more expensive more slowly than other cheaper cities.

Problems of the transformation of capital cities

Transformation modeling is based on the hypothesis that at least half of the top 10% of the highest-paid people will move from the largest cities. These 10% of the population, because of their income and lifestyle, work in expensive office buildings, rent expensive apartments, spend money in shopping centers, take taxis, visit cafes and clubs. The remaining 90% of the population either do not have income for expensive and frequent consumerism, or work for such consumerism as drivers, salesmen, and technicians. Therefore, only the direct effect of moving half of the wealthiest means a loss of 25% of income and expenses and an even greater multiplier effect.

The net profit of shopping and office centers has been good for many years, if it reaches 3-5% with an average occupancy rate of 90% by tenants during boom times. The withdrawal of 25% of revenue knocks out many tenants in the negative and increases the available space, and the growth of available space gradually reduces the rental rates of rented metres. During the anti-COVID restrictions, it was the owners of commercial real estate who panicked the most, and the drop in rental rates for expensive apartments reached 35-50%.

In small towns, it’s possible to drive less, buy less gas, and use one’s existing cars for longer. Remote work requires less expensive clothes, business lunches, gatherings with colleagues in the evenings in cafes and clubs. Lower prices for buying and renting real estate in the regions mean less spending by those who left or returned from the capital, and lower salaries for local workers and engineers. These theses will be confirmed by those who have left Moscow for accommodation and remote work in the conditional Gelendzhik or Yaroslavl, from New York to the conditional Florida or Boston.

Rents are sinking significantly, accounting for up to 25-35% of residential real estate in metropolitan cities. A significant drop in the turnover of shopping centers, public catering, taxis, and repairs affects the income of these trade and service workers, and their ability to rent even moderately expensive apartments in the capital. If owners of expensive apartments in the center of the capital can keep decent incomes even with lower prices, then owners of cheap apartments on the outskirts or in the suburbs will receive only minimal income, adjusted for utility costs, interior design, downtime.

The huge price of properties and high property taxes even before COVID made the real return on real estate investments less than deposit rates. Interest in real estate was fuelled only by the first inflationary jump against the background of still low rates on deposits and mortgages. The political need to curb inflation by raising interest rates will worsen the real estate economy of major cities.

The budgets of the largest cities are largely dependent on real estate taxes (significantly in New York and London, moderately in Moscow). An increase in vacant space, a drop in rental income and lessee revenue directly reduces income tax receipts. The fall in real estate profitability provokes a decrease in its market value and an increase in demands for revising the property tax base. New York was in a pre-bankruptcy state in the mid-1970s, as tax revenues stopped growing even against the backdrop of inflation, and state employees and bondholders demanded indexation of wages and rising interest rates.

Return from quantitative growth at the expense of the service sector to industry

Once the largest cities were centres of science and industry. Research and development (R & D) requires the work of teams in research laboratories and experimental production facilities, which cannot be done in the paradigm of office-remote work. Successful R & D projects require highly paid specialists, whose salaries are often higher than those of typical office employees. But R & D, like any experiments, is characterised by failures, greater instability in comparison with the established “life” of office employees. It is the combination of high salaries and R & D risks that has helped push this activity out of metropolitan cities to less expensive cities and into Asian countries.

Among the largest cities, there are still leaders in industry and R & D. The San Francisco metropolitan area is known not only for computer technologies, but also for numerous startups in the field of electronics, biotechnology, agriculture, and weapons, which require laboratories and workshops. South Korea’s Seoul is home to a third of its population and most of the country’s advanced industry, including electronics, automobiles, and chemicals. The agglomeration around Milan is the financial and industrial capital of Italy, second only to Rome in the primacy of state power. Many large German cities successfully combine industrial suburbs with historical centers for wealthy residents.

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These cities tend to restrict the areas of trade and services within the framework of state policy. Permits for the construction of large shopping and office centers are extremely difficult to obtain, as the authorities understand the uselessness of excessive trade and offices. Tax breaks are given to manufacturing companies and technology startups, not boutiques, catering, self-employed taxi drivers or delivery companies. Taxes on commercial real estate and on excess residential real estate with rental potential are much higher than taxes on industrial real estate.

Another feature of these cities is expensive public transport and restrictions on private cars, since the construction of expensive interchanges combined with free travel leads to a dead end in transport and budget policies. At a minimum, the goal is to ensure full self-sufficiency of transport infrastructure, including financing capital expenditures at the expense of drivers and passengers. As a maximum, transport infrastructure generates additional revenue to support science and industry. Although this primarily affects poor employees in the areas of consumerism, encouraging them to change their rented apartment in case of a change of place of work or look for work near home.

The most important feature of such cities is the leading position of large universities as channels for attracting creative youth, which is comparable in quantitative terms to the influx of low-skilled workers into the retail and service sectors. Universities are the most important complement to industry leaders and suppliers of startup participants, and young people with a focus on innovation and industry are becoming the main tenants of good apartments and customers of the consumer sector. Unfortunately, in Russia, universities are often mistakenly understood as independent innovation structures in isolation from the largest corporations.

Return of scientific and industrial leadership to Moscow

Western sanctions and the need to strengthen import substitution give a powerful impetus to rethinking the structure of the Moscow economy and changing its priorities. Moscow in Soviet times was the world’s largest scientific and technical agglomeration, and we should think about returning to that paradigm of city development. This will require a lot of public and private money, and it can be found through changes in the city’s spending and taxes.

Moscow’s annual budget expenditures on transport construction are comparable to the federal budget expenditures on science and higher education across the country, and the losses of the Moscow Metro and “Mosgortrans” are comparable to federal expenditures on Moscow State University and St. Petersburg State University. On the contrary, the profit of the Central Suburban Passenger Company (suburban trains) is twice as much as the losses of “Mosgortrans” at moderate fares compared to New York or London. The construction of interchanges and highways does not solve the problem of traffic jams, and there is a need for reasonably chargeable roads for the rich and a more expensive metro for employees of low-priority industries, so that these additional revenues can subsidise transport surcharges for pensioners, state employees, science and industry workers.

Unsuccessful and outdated shopping and office centres in Moscow are beginning to be converted into apartments. This at least reflects the problem of redundancy of such real estate and rethinking the issuance of permits for the construction of new facilities. Closing some outdated and unprofitable properties will allow buyers and tenants to concentrate in a smaller number of properties, increase their profitability, rent and taxes. In this way, taxes on industrial real estate can be reduced, and the return of commercial real estate for scientific institutions and pilot industries can be stimulated.

The potential for growth in residential property taxes is also significant, since such taxes remain an order of magnitude less than New York and London in terms of tax rates and share in city budget revenues. An increase in taxes on residential real estate should be combined with a more targeted adjustment of tax deductions and subsidies for owners of small single apartments with a long “experience” of owning and working in the public sector, science and industry.

The released workers of the reduced surplus trade will create a surplus of workers, reduce earnings in trade and thereby make work in industry more attractive. The recognition of numerous self-employed taxi and delivery workers as employees with social contributions and personal income tax will create additional tax revenues as a source of budget support for science and industry. Clarifying the tax regime of individual entrepreneurs and reducing payments of salaries in envelopes to employees of these entrepreneurs also has a great fiscal potential for stimulating science and industry.

Sergey AnureyevProfessor at the Department of Public Finance of the Financial University under the Government of the Russian Federation

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