NOTES

Guaranteeing Future Claims of Farmers in Land Acquisition: An Option-Pricing Approach

Sugata Marjit

This note suggests an optionpricing approach to tackle one problem in land acquisition.

This is based on an invited lecture delivered at Presidency College, Kolkata. I am indebted to two referees for helpful comments. The usual disclaimer applies. Sugata Marjit (marjit@gmail.com) is at the Centre for Studies in Social Sciences, Kolkata.

cquiring land for the purpose of industrialisation, public investment in infrastructure and real estate development has turned out to be a daunting task for private entrepreneurs and the government. Such problems in West Bengal, Maharashtra, and Uttar Pradesh and tribal areas have led to huge social and political unrest. The recent incidents in Uttar Pradesh have once again brought the land pricing problem to the forefront of such debates. The bill on land acquisition, waiting to be tabled in Parliament, faces continuous adjustments to accommodate the farmers concerns. There are potentially several wellknown problems and issues related to land pricing such as absence of properly functioning land markets, fragmented holdings, mode of bargaining and determination of reservation price, intermediation and brokers, political arm-twisting, compensation to landless agricultural workers, etc. This note is not an attempt to offer a solution for all such problems, but it attempts to solve a key economic problem that seems to affect all such deals. This has to do with the claim of the landowner over the future value of land once it is sold and put to alternative use. Let me state the problem clearly and suggest a solution that is borrowed from the idea of option-pricing in the theory of nance and is integrated with the conventional idea of taxation of capital gains. This will provide the foundation to the logic of an annuity or a royalty, currently much talked about in policy circles. It is surprising that policy specialists are yet to nd the link of the reigning problem to option-pricing theory. Although, there has been some work on real options related to real estate development literature, application of the idea of the option in the

contemporary political/economic context in India is reasonably novel (RICS 2007). While the attention of the readers will be immediately drawn to the idea of an option, the more interesting aspect of my argument lies in the integration of the concept of a capital gains type tax to an operational de facto option market. This note is also addressed to the adaptation of the so-called Haryana model which relies on predetermined annual payments to the farmers. Any arbitrary future valuation such as annuity without specifying a proper mechanism that clearly relates the future value to the market, will lead to unnecessary arbitrage and consequent governance problems. The basic intuition behind the mechanism is as follows. Fundamentally, the problem is one of guaranteeing to the seller of land a fair share in the augmented value of the land in the future as the value can really shoot up once the land is put to use. At the same time the future value of any asset or land is not realised now and the seller and the buyer will have natural disagreements on the future value. The buyer will try to misinform the seller to get a price advantage, etc. What I propose in this brief technical note is to argue that the seller will have a legal claim on the future increased value of land. The government will tax a portion of that increased value from the buyer and redistribute it to the landowner and thus the government will be involved in the process, not as a negotiator, but as the legal taxing authority. The seller will forfeit his property right to the buyer, but will have a rightful claim on the capital gain tax imposed by the government. We should remember that the case by case arrangements such as giving the buyer the ownership of real estate built on the land, or the shares of the company setting up the industry, or jobs in the company will have a lot of undesired economic and political consequences that buyers and sellers can manipulate. Also the nature of the land use will vary considerably. So in general one has to focus on the market value of land in the future and treat the augmented part of the value as a capital gain which can be taxed following the standard practice. A novel part of the
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mechanism is that it binds the government to distribute the taxes, or a part of it, to the original sellers. Another novel aspect of the mechanism is that the claim paper that is obtained by the seller after the sale of land in the current period is a legal instrument which entitles him to receive a part of the capital gain tax and that instrument can be traded in the market. A poor farmer who sells his land at a low price today, but is condent that the price will increase substantially in the future cannot get the part of the future price now even if he has that claim paper. But he can sell that paper to someone who can wait to receive the extra value in future. So if the farmer expects to receive Rs 10,000 from the government next year, he can sell the piece of paper at Rs 8,000 today. If I am buying that paper, I shall get Rs 10,000 tomorrow and make a prot of Rs 2,000. The farmer gets the money much earlier and does not have to wait and I make some prot. This is a win-win situation. Now let us turn to some technical details. Consider a simple two-period framework and a single seller, single buyer transaction problem over a unit of land. The price of land today will be the sum of the current period returns from land and the value of discounted stream of returns from land in future. In our framework we shall have only two periods, the present and the future. The buyer and the seller have agreed on the value of the current period return from land, call it V1 but they differ in opinion on the extent of future appreciation of such returns. These are real returns above and beyond the ination rate. The buyer thinks that it will be V2b and the seller anticipates it to be V2s with V2s > V2b. V1 is interpreted as earning from using the land in period 1 and V2 is the earning from using the land and then selling it next period. Therefore, sellers desired price Ps must be such that Ps V1+ V2s [ is a discount rate: 0<< 1] Similarly for the buyer: Pb V1 + V2b Since V2b < V2s, maximum Pb < minimum Ps. Therefore, as such land will not be sold. The problem is that future valuation is unknown and uncertain in the present period, except the fact that the future value will be greater than V1. Even if the government mediates, the seller is
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not likely to trust political interference if they are forced to accept V2b. We have already experienced violent consequence of such concerns. Suppose, there was a mechanism by which the seller gets Pb now with V2b as the stipulated value and is guaranteed of a share in the future capital gain on land. ~ Let V2 be the actual value in period 2, but can be known only at the beginning of period 2. So the seller will get a fraction of ~ ~ ( V2 V2b) if V2 > V2b and will voluntarily ~ opt out if V2 V2b. This seems to be fair from the point of the seller and the buyer. ~ If total ( V2 V2b ) could be guaranteed, ~ ( V2 V2b) will go to the seller and the ~ rest (1 )( V2 V2b) will go to the buyer. The question is how to design an enforceable contract now based on the future value of the land. Note that even if the ~ buyer does not realise V2 next period explicitly by selling the property, she is liable to pay the share of the value because she can collateralise the increased market value of the asset to get fresh loan, augment the amount of borrowing and the rm value will incorporate the enhanced value of the asset. The following mechanism will solve the problem. The seller currently gets the value V1 + V2b and a piece of paper which states that the seller has the option to deposit the paper with the government ofce, called the Capital-Gain on Land Evaluator and ~ get the amount ( V2 V2b). is decided ~ beforehand and V2 is known in the second period as V1 was known in the rst period, at the beginning of the deal. ~ The evaluator will tax ( V2 V2b) from the buyer of the land as a capital-gain tax. Actually the shares of the capital-gain retained by the buyer and given to the seller may not add up to 1. The government can charge something as processing costs. The basic idea is to redistribute part of the capital gain to the seller via a taxation process. Evaluation of capital gain and governments sovereign power of taxation ~ is well accepted in asset markets. If V2 somehow falls below V2b because the project does not take off or falter, the seller will not exercise her option. This is basically the idea of the option. Let the expected value of the piece of paper to the seller be given by (V2 V2b)
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~ where V2is the expected value of V2 as anticipated by the seller. The seller may have ~ her own idea, information, etc, about V2 and may expect a value V2 (even if V2 is not the exact expected value in statistical sense). So the seller will be willing to sell the option paper to anyone who pays her an amount greater than (V2 V2b). Therefore, if there is someone who knows ~ that V2 > V2 , he will pay the seller right now an amount the latter wants. The new buyer will be entitled to the share of capitalgain tax next period. Thus the piece of paper, or the option, must be allowed to be traded in the market. The poor seller may need the money now and someone who is not the original buyer of the land will be willing to invest the amount now and wait for the redistributed capitalgain tax next period. This mechanism has to be supported by the following regulations. (a) A well-specied has to be agreed upon independent of the nature of transactions, so that no piecemeal, case by case decision is negotiated. It will be a debated, decided and xed as a statutory provision. (b) Use a part of the taxation infrastructure at the central level for evaluating capital-gains on land and create accounts to be exclusively used for this purpose. For the buyer, the seller, the government and the option trader. This needs to be done so that funds raised do not go towards other kinds of scal replenishments. Also one can track the transactions between the seller and the option trader, etc. The proposed mechanisms basically solve the problem of guaranteeing the sellers share in future capital gain on land. Option as a traded instrument can satisfy the mass of poor farmers without binding the buyers of land. It is well known that imperfection in capital market

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does not allow a poor farmer to borrow. At the same time there are entities that can borrow and nance transactions. If they are condent of the capital gains, they will provide the liquidity to the farmers. They can do it in a transparent manner and some of the unrealised future values will reach the farmers right away. Let me now try to counter some of the possible concerns which may have been ignored in the analysis. The idea of the option paper being allowed to be traded assumes that there will be a secondary market for options. What if that market is not allowed to exist? This will be really unfortunate. Absence of properly functioning markets is the root cause of the trouble. Even if we cannot straighten the land rights issue immediately, once a land is transacted and the seller obtains the claim paper it should be allowed to be traded. The poor will benet because of the immediately available liquidity and more patient trader will wait for better fortune. If farmers all over are increasingly becoming market savvy, there is no reason why the new market form will not be encouraged. The buyer may actually delay land development and deprive the seller of his

claims. Note that once the land is sold, in our system the buyer will be forced to pay a capital gain like tax, no matter whether the land is developed or not. This will provide the incentive to develop the land quickly. One has to remember that if the developer adds value by postponing development, he or she is liable to pay tax on the increased option value to the government who, in turn, transfers it to the seller. It is easy to contemplate the following types of possible land use. (1) For real estate development: In this case promoters will be liable to pay the tax and then those who will subsequently own the property. This will be like urban tax to be collected by the State but with constitutional stipulation of transferring it back to the purchaser. (2) For setting up industries: Such tax can be postponed till the business becomes operational. Government estimates and pays the sellers in the interim period and recovers later from the corporate. (3) Public infrastructure development: Direct payment from the government over time can be designed. Note that in all such cases if claim paper could be traded, the farmer or landowner may have the option to sell that paper and

get out. It goes without saying that the proposed framework is just an outline of an idea or a mechanism. Therefore, it needs careful scrutiny. However, the idea of options, alive and kicking for so long, must be utilised to guarantee future claims of the farmers. Any arbitrarily chosen amount of royalty, future compensation, etc, is not going to work because forces of market cannot be substituted by regulations. If there are people who believe that the market for acquired land will boom and add to the value of the rm or the asset, the market for options will automatically ourish. A poor farmer will get the enhanced asset value by selling their options. Can the government act as an option trader? It can but it should not. If the government loses by paying an excessive price for the option today, society at large will lose. Also the incentive structure is not in order within the government. It is better that the government facilitates such trading rather than become a business partner in the process.
Reference
RICS (2007): A Real Options Approach towards Development Land Valuation (UK: University of Aberdeen).

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