|legal theory: law and economics|
Economic Analysis of "Takings" of Private Property [*]
A crucial constitutional question since the founding of the United States has been the extent to which the state and federal legislatures are permitted to impair private property rights. From the beginning, American courts have recognized that governments must be accorded some latitude in setting and modifying the entitlements associated with the ownership of land and other commodities. The courts have refused, however, to acquiesce in all legislative interferences with private property rights.
The constitutional provisions used to shield property from governmental encroachment have changed over the course of American history. Until the end of the nineteenth century, most regulations of private property emanated from the state governments, not the federal government. That fact -- combined with the Supreme Court's ruling that the Bill of Rights was inapplicable to the states -- minimized the significance of the Fifth Amendment's ban on uncompensated "takings" of private property.  In the limited number of cases in which the Supreme Court undertook to review challenges to allegedly confiscatory legislation, it based its rulings either on broad principles of natural law or on the contracts clause of Article I, Section 10.  In 1897, the Supreme Court held for the first time that the due-process clause of the Fourteenth Amendment "incorporated" against the states the takings clause of the Fifth Amendment. Since that date the stream of cases invoking the federal Constitution to challenge legislative or judicial impairments of property rights has steadily increased.
Before World War II, legal scholars paid relatively little attention to the so-called "takings" doctrine. Since the 1950s, however, the body of academic writing dealing with the issue has mushroomed. The ambition of the large majority of the authors who have contributed to the discussion has been to define a principled line that would enable the courts to differentiate permissible "regulation" of private property from impermissible (if uncompensated) expropriation thereof. Prominent among those who have attempted this feat have been economists.
EXERCISE -- part 1
Before you launch into the economic analysis, take a moment to read (an edited version of) the facts of one of the most famous Supreme Court decisions interpreting the takings doctrine: Penn Central Transportation Co. v. New York City, 438 U.S. 104 (1978). Ask yourself: who should have prevailed in the case.
Economic analysis of the takings doctrine can be traced to a 1967 Harvard Law Review article in which Frank Michelman argued (among other things) that a judge called on to determine whether the Fifth Amendment had been violated in a particular case might plausibly select as her criterion of judgment the maximization of net social welfare.  If that were her ambition, Michelman contended, the judge should begin by estimating and comparing the following economic impacts:
Michelman's definition of the third of these terms was original and critical; to ascertain the "demoralization costs" entailed by not paying compensation, the judge should measure "the total of . . . the dollar value necessary to offset disutilities which accrue to losers and their sympathizers specifically from the realization that no compensation is offered, and . . . the present capitalized dollar value of lost future production (reflecting either impaired incentives or social unrest) caused by demoralization of uncompensated losers, their sympathizers, and other observers disturbed by the thought that they themselves may be subjected to similar treatment on some other occasion."
Once the judge has calculated these impacts, Michelman contended, her job is straightforward.
Applying this composite test, Michelman suggested that some of the guidelines employed by the Supreme Court when deciding takings cases, though seemingly simplistic or senseless, turn out to have plausible utilitarian justifications. For example, the rule that "physical invasion" by government of private property is always deemed a taking, though apparently a clumsy device for separating mild from severe encroachments on private rights, turns out to have important redeeming features: it identifies a set of cases in which settlement costs (the costs of both ascertaining liability and measuring the resultant damages) are likely to be modest and in which, because of the "psychological shock, the emotional protest, the symbolic threat to all property and security" commonly associated with bald invasions, "demoralization costs" are likely to be high -- precisely the circumstance in which compensation is most appropriate. Similarly, the courts' sensitivity in takings cases to the ratio between the economic injury sustained by the plaintiff and the overall value of the affected parcel (rather than to the absolute amount of the economic injury) makes some sense on the following plausible assumptions: "(1) that one thinks of himself not just as owning a total amount of wealth or income, but also as owning several discrete things whose destinies he controls; (2) that deprivation of one of these mentally circumscribed things is an event attended by pain of a specially acute or demoralizing kind, as compared with what one experiences in response to the different kind of event consisting of a general decline in one's net worth; and (3) that events of the specially painful kind can usually be identified by compensation tribunals with relative ease."
EXERCISE -- part 2
Recall the facts of Penn Central. If the Supreme Court had decided the case using Michelman's formula, who would have won? You may find helpful, in this connection, Justice Rehnquist's dissenting opinion. Rehnquist is speaking in the language of fairness, not efficiency, but his reflections bear indirectly on the Michelman paradigm.
Michelman's analysis proved highly influential among constitutional scholars, but did not go uncontested. In the 1980s, several younger scholars argued that Michelman had made a crucial mistake. When measuring "demoralization costs," they argued, a judge should not include the diminution in investment and "productive activity" caused by not making the victims whole. Indeed, widespread adoption of Michelman's strategy would send precisely the wrong signal to property owners; assured that they would be indemnified if and when the public needed their land, they would overinvest in capital improvements -- and, in particular, in capital improvements likely soon to be rendered obsolete by governmental action or regulation. Inducement of efficient kinds and levels of activity, the revisionist economists claimed, requires that economic actors "bear all real costs and benefits of their decisions" including the risk of future changes in pertinent legal rules.
EXERCISE -- part 3
Does this insight change your view concerning the proper result in Penn Central?
From this point (now widely considered convincing), economic analysis of the takings doctrine has radiated in a variety of directions. Here are a few:
Insurance Schemes. The guideline just mentioned (that efficiency will be enhanced by forcing landowners to bear the risk of future changes in pertinent legal rules) has at least one serious drawback: It may result in a few landowners suffering very large, uncompensated losses -- a situation economists generally regard as undesirable.  From an efficiency standpoint, the best solution to this problem would be the development and widespread use of a private insurance system. Landowners would buy "takings" insurance, just as they now routinely buy fire insurance. Such a system would not erode the benefits of making landowners bear the costs of regulation, because the rate that an insurer charged for insuring a particular parcel would almost certainly reflect the likelihood that that particular parcel would later be subject to governmental action. For example, developers who bought land in flood plains or on eroding beaches would pay very large premiums, while landowners in lower-risk areas would pay much lower premiums. The resultant incentive to avoid developing parcels likely soon to be regulated is precisely what we would wish to create. 
Unfortunately, a private market in "takings" insurance has not yet developed. Various reasons have been suggested for this failure, but the fact remains that landowners cannot currently shield themselves against uncompensated takings. Even if private insurance were available, some landowners undoubtedly would not purchase it -- because they systematically underestimated the danger of regulation or because they were simply poor planners. Under these nonideal conditions, some economists have conceded that governmental compensation for severe land-use regulations may be economically defensible as, in effect, a form of compulsory state-supplied insurance.
EXERCISE -- part 4
Suppose that the courts routinely denied compensation in cases like Penn Central. One way in which major investors might respond (in the absence of a private takings-insurance market) is by diversifying the kinds of properties they purchase and hold -- thus effecting a kind of self-insurance. Conceivably, Penn Central did exactly that. For Justice Brennan, the significance of the fact that Penn Central owns many other parcels in the city -- "the Barclay, Biltmore, Commodore, Roosevelt, and Waldorf-Astoria Hotels, the Pan-American Building and other office buildings along Park Avenue, and the Yale Club" -- is that it has several lots upon which it might use its "tranferrable development rights." But conceivably the reason why Penn Central (a railroad, after all) holds on to parcels of those diverse sorts is to reduce its exposure to overwhelming loss through "spot" zoning changes. If this (highly speculative) explanation were true, should economists be pleased or disturbed?
Reconstructing Demoralization Costs. Perhaps the revisionist critique of "demoralization costs" has gone too far. After all, many people become unhappy when they experience or witness uncompensated severe regulations of private property, and those psychic injuries (measured, as always, by people's willingness and ability to pay money to avoid them) must be considered when one tries to design a takings doctrine that maximizes net social welfare. Moreover, those costs go further than the (potentially substantial) disutilities caused by the frustration of people's "political preferences" -- the pain they experience when they witness behavior they consider unjust. They include secondary effects that might be called "search costs":
A judicial decision denying compensation in defiance of a popular perception that it should be forthcoming risks undermining people's faith that, by the large, the law comports with their sense of justice. Erosion of that faith, in turn, would reduce people's willingness to make decisions -- the rationality of which depends upon the content of the pertinent legal rules -- without taking the time to "look up" the rules. . . . Generally speaking, our willingness to act in this fashion is efficient; as long as the rules are in fact consistent with our senses of justice, it is desirable, from an economic standpoint, that we trust our intuitions. Any material diminution in that willingness would give rise to deadweight losses that merit the attention of a conscientious economist.
Determining the magnitude of demoralization costs of these various sorts is, however, very difficult. Frequently, one can argue plausibly that the psychic injuries caused by a particular sort of regulation will be huge -- or will be insignificant. Consider, for example, the situation in which land-use regulations are suddenly tightened, not by the legislature, but by a change in common-law rules. Will the demoralization costs caused by such putative "judicial takings" be smaller or larger than those associated with comparable "legislative takings"? Barton Thompson points to several circumstances suggesting that they will be smaller: the fact that courts can more easily disguise the extent to which they are changing the pertinent land-use regulations; courts' ability to fall back on their general reputation for objective and principled decisionmaking; and the tendency of the doctrine of stare decisis to mitigate landowners' anxieties that judicial modification of one land-use regulation portends more sweeping changes in the future.  Barton acknowledges, however, that many of these factors can be "flipped," suggesting that judicial takings will result in unusually high demoralization costs:
The mysteries and insulation of the judicial process, for example, might actually increase demoralization. Property holders may believe that they at least understand the legislative process, have some electoral control over politicians, and know how to wage a fight on political grounds. They may feel far more distressed about a legal process that affects them without apparently understanding their concerns, speaks in a foreign and confusing tongue, and is directed by judges over whom they feel they have no effective popular control. Given the existence of stare decisis and people's expectations that courts will generally observe precedent, moreover, property holders may fear disintegration of the social structure far more when a court significantly modifies prior property law than when the legislature engages in traditional political behavior. 
Barton's avowedly indeterminate analysis of "judicial takings" is typical of the murk one enters when trying to predict psychic injuries. In short, demoralization costs are plainly relevant to the design of an efficient takings doctrine, but their uncertainty makes economists queasy about relying on them.
EXERCISE -- part 5
Recall your initial response to the Penn Central problem. Which party did you think should prevail? To what extent and in what ways would you individually have incurred "demoralization costs" (of any of the sorts discussed above) if the decision had come out the other way? Of course, to estimate aggregate demoralization costs, you would need to know how representative your views are. What percentage of Americans, do you suppose, share your attitude concerning the legitimacy of uncompensated government regulation of this sort? If you are curious, on this point, complete the attached survey, then compare your answers to those of various other groups.
"Fiscal Illusions." Several economists have argued that it is mistaken to concentrate exclusively upon the effect of constitutional doctrine on the incentives of landowners to use and improve their possessions; one must also take into account the incentives of government officials to regulate private property. Specifically, these economists have argued that, unless government officials are compelled somehow to bear the costs of the regulations they adopt, they will tend to impose on private property inefficiently tight land-use controls. In this respect, the position of the government vis-à-vis private landowners is similar to the position of a private landowner vis-à-vis her neighbors. The purpose of nuisance law, it is often said, is to force each landowner to internalize the costs of her activities and thus discourage her from acting in ways that impose on her neighbors inefficiently high levels of annoyance (smoke, smells, pollution, excess light, etc.). Similarly, some economists have argued, the purpose of a just-compensation requirement is to compel government officials to internalize the costs of their regulatory activities and thus discourage them from fettering landowners excessively.
This claim has been subjected by other economists to two sorts of critique. First, it is not altogether clear that, unless deterred by a just-compensation requirement, government officials will overregulate. Louis Kaplow points out that, although it is true that (in the absence of such a requirement) government officials will not bear the costs of their regulatory activities, they also will not reap the benefits of those activities. (In this respect, they are different from potentially hyperactive private landowners.) There is thus no reason to assume that, unless leashed by a strict takings doctrine, officials will run amok.  A student Note in the Harvard Law Review reinforces this point by suggesting two reasons why government officials might be prone to adopt inefficiently low levels of regulation: (a) ordinarily, the beneficiaries of land-use restrictions are more dispersed (and thus less able to make their views known to their elected representatives) than the landowners adversely affected by those regulations; and (b) government officials typically undervalue the interests in regulation of the members of future generations.
Second, even if the "fiscal-illusion" effect is serious, it is not obvious that the enforcement of a constitutional just-compensation requirement is the only -- or best -- way to offset it. Other strategies might work as well or better. For example, the student Note just mentioned contends that optimal levels of regulation might be achieved equally effectively by assigning to the state the authority to proscribe without compensation any uses of private land that government officials believe are injurious to the public -- but then permit adversely affected landowners to buy from the government exemptions from those regulations. The state's police power, in other words, could be treated as an alienable servitude. Unless transaction costs interfered with the market in such exemptions (concededly a tricky issue), the adoption of such a system should (Coase tells us) result in the same, efficient level of regulation as a regime in which landowners were originally assigned the right not to be regulated and the state had to expropriate (through the payment of "just compensation") the authority to regulate them.
EXERCISE -- part 6
How, if at all, do concerns of these sorts affect your view of the right outcome in Penn Central. Are you persuaded by Justice Brennan's characterization of the laudable motivations behind the New York City regulation. Or does Justice Rehnquist's much harsher view seem more realistic? (For an even darker view of the impulses that typically guide public officials, check out Justice Scalia's dissenting opinion in Pennell.)
We observe that the [land] uses in issue in Hadacheck, Miller, and Goldblatt were perfectly lawful in themselves. They involved no "blameworthiness, . . . moral wrongdoing or conscious act of dangerous risk-taking which induce[d society] to shift the cost to a particular individual." These cases are better understood as resting not on any supposed "noxious" quality of the prohibited uses but rather on the ground that the restrictions were reasonably related to the implementation of a policy -- not unlike historic preservation -- expected to produce a widespread public benefit and applicable to all similarly situated property.
For better or worse, however, the Court since Penn Central has drifted back toward its original view. The justices' invocations of the distinction between "noxious" and "innocent" uses have been more tentative and awkward than in the period before 1960, but nevertheless have been increasing.
The Court's opinion in Loretto v. Teleprompter Manhattan CATV Corp. furnishes a more straightforward illustration of the power of the economic argument. At issue in the case was a New York statute empowering a cable television company to install fixtures on the sides and roofs of privately owned buildings. In holding that such a "permanent physical occupation" of private property, no matter how trivial, always constitutes a taking, Justice Marshall relied twice on Michelman's 1967 article -- first, for Michelman's analysis of the historical development of the physical-occupation rule; and second for his defense of the rule as effective way of identifying situations involving both low settlement costs and high demoralization costs.
The newer and more refined variations on the economic theme, however, have had little if any impact on judicial decisions in this field. In particular the danger -- widely recognized by scholars -- that liberal grants of compensation to property owners adversely affected by government action will give rise to a "moral hazard" problem, leading to inefficiently high levels of investment in improvements likely to be rendered valueless by subsequent regulation seems to have fallen on deaf judicial ears.
Equally troublesome is the tendency of judges (or their law clerks) to misuse economic arguments -- or at least to deploy them in ways their originators would have found surprising and distressing. Perhaps the clearest illustration of such misuse concerns the fate of the phrase: "discrete, investment-backed expectations." Toward the close of his 1967 article Michelman provided a brief, avowedly utilitarian defense of the venerable and much-maligned "diminution in value" test for determining whether a statute had effected a taking. The true justification of the test, he argued, is that, like the physical-invasion test, it mandates compensation in situations in which property owners will experience severe psychological injury. Recognition of this justification, Michelman went on to argue, requires that we reconceive the test slightly:
"More sympathetically perceived, however, the test poses not [a] . . . loose question of degree; it does not ask "how much," but rather . . . it asks "whether or not": whether or not the measure in question can easily be seen to have practically deprived the claimant of some distinctly perceived, sharply crystallized, investment-backed expectation."
In his Penn Central opinion, Justice Brennan several times invoked the language with which Michelman closed his discussion -- without recapitulating, however, the argument on which it was based. Cut loose from its moorings, Michelman's proposed test has since been put to some surprising uses. For example, in Kaiser-Aetna v. United States, the owner of a resort and marina in Hawaii argued that, by granting it permission to convert a shallow, landlocked lagoon into a bay accessible to pleasure boats, the Army Corps of Engineers had forfeited the right subsequently to declare the bay a navigable waterway open to the public -- unless, of course, it compensated the marina owner. Emphasizing the large amount of money the petitioner had invested in the project, Justice Rehnquist and a majority of the Court agreed. A well-established factor in assessing takings challenges, Rehnquist held, is the extent to which the challenged government action "interfere[s] with reasonable investment backed expectations." In the case at bar, the interference plainly had been substantial. Whatever one thinks of the merits of the ruling, it is considerably removed from Michelman's original point, namely, that total or nearly total devaluation of a distinct property interest (something that plainly did not occur in Kaiser-Aetna) should be deemed a taking because of its likely psychic impact on the owner of the property.