The Cost of Kelo

Most would agree that government should have the power to promote the public good by seizing property from private individuals to build a school, highway, lighthouse or bridge—projects that fulfill a public purpose by directly serving the community at large. But should the government also have the power to take property from one private citizen and give it to another for the ostensible sake of economic development?

Last summer, in Kelo v. City of New London,¹ the U.S. Supreme Court answered this long-standing question in the affirmative, a decision that ignited a nationwide firestorm of protest by defenders of property rights. Unfortunately, this decision was seriously flawed, and unless reversed, its costs will be considerable. The Court erred by ignoring clear economic evidence that taking private property from one citizen and giving it to another, even in the name of job creation and economic development, does more harm than good.

The issue of how far the power of eminent domain should extend into the private realm dates to Colonial times. Historical debate over condemnation power—the constitutional right of government to take private property "for public use," with just compensation—has been guided not by one principle of public use, but by two.

The first defines public use narrowly as utilization by the community at large, while the second interprets public use as "public purpose"—anything that provides some benefit to the public, even when the benefits are not necessarily available to every member of the community. The Kelo decision embraced the second interpretation, explicitly declaring that taking private property from one citizen and giving it to another in order to promote economic development is a legitimate public purpose under the Constitution.

Property-rights advocates argue that the broad, public purpose reading of Constitutional restrictions on eminent domain severely erodes property rights, the foundation of the U.S. economy. Local governments, developers and others who favor an expansive interpretation of public use counter that even unambiguous public uses, such as parks and highways, compromise individual property rights. Therefore, they say, the litmus test for eminent domain should be whether the public benefits of a taking outweigh its costs to society. Proponents of the public purpose view claim that economic development does pass that test, by creating jobs and boosting tax revenues, often in economically distressed communities. That argument seems to make sense, and in Kelo, the high court didn't question the advertised public benefits of new, privately financed construction in New London, Conn.

But economists have found that economic development is not a public good, nor does it pass the public benefit/cost test. Markets efficiently allocate resources to economic development without any interference from government. There is no market failure as there would be with public goods—roads, parks, sewer lines and other community services and amenities. As a result, government meddling in economic development decisions only leads to a less efficient use of resources.

Moreover, while the benefits of using eminent domain as an economic stimulus are illusory, the costs are not. Permitting government to take property from one private entity to give it to another, even if the taking is compensated, implies some degree of coercion. This coercion impairs the willingness of the private sector to invest, and ultimately impairs the economy's ability to grow.

Dueling definitions of public use

The U.S. Constitution addresses eminent domain in the "takings clause" of the Fifth Amendment, delimiting the government's right to appropriate private land: "[N]or shall private property be taken for public use, without just compensation."² Founder James Madison, who drafted the original language of the clause, feared that left unrestricted, the power of eminent domain could jeopardize private property rights, the bedrock of any free society.

Yes, the ability to condemn property for public use was necessary to prevent what economists call the "holdup problem"—landowners holding public projects hostage in hopes of obtaining an inflated price. But Madison and the other landholders who framed the Constitution believed that property owners deserved fair compensation, and an assurance that any taking would serve the common good rather than private interests. State constitutions, which governed condemnations by local governments before the Bill of Rights applied to the states, contain similar takings clauses.

The courts, however, have never managed to parse the "public use" requirement in the takings clause to everybody's satisfaction. Does the Constitution allow condemnation for private development that purports to benefit the public as well, or not? Over the past two centuries, these two words have incited endless debate, with most judges and legal scholars articulating either a narrow or a broad definition of public use.

A narrow, "actual-use" reading assumes that the public must have physical access to the condemned property. Under this definition, a public road or city park qualifies as a public use; an office park or condominium does not. Advocates of this view maintain that a literal reading of public use is in keeping with the spirit of the takings clause, based on tenets of political philosophy in vogue toward the end of the 18th century: Takings of private property should be limited to circumstances in which every member of the public is entitled to benefit from the taking, in equal measure.

Under a broader, "public purpose" interpretation of public use, forcibly transferring property from one private owner to another is justified as long as the public derives some incidental benefit from the taking. A commercial development, such as a factory, shopping center or casino, may primarily benefit private entities, but it also generates jobs and additional tax revenue for the community—an ostensible benefit to the community at large.

Both interpretations of public use have been in play since the nation's founding, but state and federal courts have increasingly adopted the public purpose view, opening the door wider and wider to condemnations for private development (see sidebar).

Economic development as public purpose

In resorting to eminent domain, local governments argue that seizing private property to make way for office parks, shopping centers, townhouses and other new development is sometimes necessary to revitalize core cities and older suburbs. Acquiring the property of holdouts at prevailing market values makes it easier for a built-up community to assemble a large tract of land from multiple, individually owned parcels and resell it to developers—thereby raising property values, creating local jobs and generating more tax revenue.

Although some state and lower federal courts have struck down such takings on the grounds that they violate the public use requirement, most courts have allowed them, taking their cue from U.S. Supreme Court rulings that permitted condemnation for urban blight and redistribution of property, and a 1981 Michigan Supreme Court decision that allowed an entire neighborhood to be razed for the construction of an automobile plant.³

The Institute for Justice, a public-interest law firm based in Arlington, Va., has catalogued thousands of examples of condemnations for private development in recent years.⁴ Often one of the stated objectives is eliminating blight; by law in many states, a finding of blight is required to take land through eminent domain. But almost without exception, the conditions cited by city officials bear little resemblance to the inner-city slums that courts deemed worthy of condemnation and leveling a generation ago. The primary goal in these takings is to stimulate the local economy by putting land to a presumed higher and better use.

In a case currently before the Ohio Supreme Court, the Cincinnati suburb of Norwood condemned homes in a working-class neighborhood three years ago for a $125 million office and retail development. Saying that increased tax revenue from the project would boost its economy, the city justified the takings on the basis that the neighborhood showed signs of deterioration, including "obsolete platting" (small front yards) and "faulty street arrangements" (dead-end streets). In Riviera Beach, Fla., one of the most ambitious uses of eminent domain in the country would replace the homes of over 1,300 people with a 400-acre residential and boating complex. The stated goal of the planned $1 billion development is to "forever change the landscape" of the largely black, working-class city in order to attract commercial development and generate badly needed jobs.⁵

Kelo blessed condemnation in the name of economic development

The poster child for the exercise of eminent domain in the cause of economic development is, of course, the City of New London. The Kelo case made Susette Kelo and eight other property owners who tried to thwart the city's redevelopment plans famous. In its first major ruling on eminent domain in 20 years, the U.S. Supreme Court sanctioned New London's taking of private property to foster economic development. The broad concept of public purpose again prevailed over the narrow, actual-use definition of public use.

In moving to condemn Kelo's house and other holdout properties as part of an "integrated development plan" for the city's Fort Trumbull area, the city's development agency made its motives clear. Blight was not a concern; the agency never claimed that the neighborhood was run down or that condemned properties were poorly maintained. City planners simply saw an opportunity to boost the fortunes of an economically distressed community with declining population and an unemployment rate nearly double that of the state.

Planned new construction—a waterfront hotel, housing, marinas, and retail and office space—was meant to capitalize on Pfizer Inc.'s decision in 1998 to build a $300 million research facility near Fort Trumbull. After demolishing more than 90 existing homes and small businesses, the New London Development Corp. would lease some acquired parcels to private developers who agreed to follow the development plan. State and city officials expected the new development to generate jobs, increase tax revenues and attract more commercial and residential development, helping to rejuvenate the local economy. Kelo and the other property owners who refused to sell sued the city in 2000, challenging a state law that allows the taking of land for economic development projects.

In its 5-to-4 decision in favor of the city, the Supreme Court held that using eminent domain to transfer property from one private entity to another with the aim of stimulating economic growth is a legitimate public use under the Fifth Amendment. The Court drew no distinction between such private development and other permissible public uses—or purposes—such as blight clearance, city parks, airports, and rights of way for highways and common-carrier railroads.

The high court based its ruling on legal precedent. But it implicitly accepted the assertions of city officials and developers that the hotel, shops, office buildings and other new construction would serve the public good by reducing unemployment and enhancing the city's ability to pay for public services and amenities. "The city has carefully formulated an economic development plan that it believes will provide appreciable benefits to the community, including—but by no means limited to—new jobs and increased tax revenue," wrote Justice John Paul Stevens for the majority. "[T]hat plan unquestionably serves a public purpose."⁶ Rejecting the argument that the use of eminent domain should not benefit private companies, the Court said that "the government's pursuit of a public purpose will often benefit individual private parties."

Noting a "longstanding policy of deference to legislative judgments in this field," the Supreme Court also said that it was up to Connecticut lawmakers to determine the circumstances under which takings served the public interest. Justice Anthony M. Kennedy, in his concurring opinion, agreed that the Court must give state legislatures the benefit of the doubt when reviewing economic regulations. Observing that the New London properties were condemned "in the context of a comprehensive development plan meant to address a serious city-wide depression,"⁷ Kennedy concluded that the takings met the rational-basis test under the 14th Amendment's equal protection clause. That is, the use of eminent domain is justified when the government has a well-founded reason to believe that it fulfills a legitimate public purpose.

Defending the castle: The property-rights backlash

Uproar ensued when the Kelo decision was handed down. Conjuring images of bulldozers knocking down houses to make room for office towers and shopping malls, the ruling was portrayed by property-rights advocates as an assault on the middle class by tax-hungry politicians beholden to developers. Politicians rushed to shield businesses and homes from condemnation in the name of economic progress: Congress is considering withholding economic development assistance from local governments that use eminent domain to facilitate private development, and more than 35 states have either enacted or proposed restrictions on such condemnations.

The Kelo decision provoked outrage because it was seen as an attack on individual property rights. Property-rights advocates, quoting from Justice Sandra Day O'Connor's dissent ("Under the banner of economic development, all private property is now vulnerable to being taken and transferred to another private owner.") complained that the ruling subjugates property rights to a nebulous notion of public purpose that renders the public use requirement meaningless. The Institute for Justice's grassroots campaign against "eminent domain abuse" is called the Castle Coalition—a reference to the sanctity of the home threatened by overbearing government.

Breaking the link to the public good

The Supreme Court ruling in Kelo, however, should be questioned not only because it attacks property rights, but also because it rests on a flawed premise. Contrary to the Court's finding, using eminent domain to take property from one private developer to give it to another does not promote economic development; in fact, such takings diminish economic activity and, therefore, the general welfare.

The justices who prevailed in Kelo saw no difference between commercial developments that are deemed by state and local officials to serve a public purpose and clearly public uses of land, such as schools, roads, parks and sewer systems. "Promoting economic development is a traditional and long accepted function of government," Justice Stevens wrote. "There is, moreover, no principled way of distinguishing economic development from the other public purposes that we have recognized."

But the high court's view of economic development is wrong. While government certainly has a critical role in promoting a sound economy, that role is circumscribed. Modern economic theory and research show that government should not interfere with most market transactions. Indeed, contradicting Stevens' assertion, economic theory says that government can distinguish between economic development—which it should not interfere with—and other land uses serving the public interest.

Public vs. private goods

To understand the government's proper role in promoting a sound economy, it's important to grasp the distinction economists make between public and private goods. That distinction and its implications were developed in the 20th century by several renowned economists, among them Erik Lindahl,⁸ Richard Musgrave⁹ and Paul Samuelson.¹⁰

Most goods are private goods, distinguishable from public goods by two properties: "rival" and "excludable." By the first, economists mean that once consumed by one person, a private good cannot be consumed by another. If Jane eats an apple, no one else can eat that apple. In contrast, public goods can be consumed by one person without reducing their consumption by others. National defense is one textbook example. Fresh air is another. As Samuelson put it, these are goods "which all enjoy in common in the sense that each individual's consumption ... leads to no subtraction from any other individual's."¹¹

The second defining property of private goods is excludability. The owner of a private good can exclude others from using it, but members of the public cannot be prohibited from consuming public goods. So, Jane can prohibit others from eating her apple, but the public can't be excluded from the protections provided by national defense.

Why is the distinction between private and public goods crucial? Because, generally speaking, markets produce and distribute private goods—apples, condos and shopping malls—most effectively when they are left to their own devices. That is, unfettered markets allocate limited resources efficiently, and government intervention in free markets leads to inefficient production of private goods and services.

However, when it comes to the production of public goods or near-public goods (those that have a significant public component), Adam Smith's invisible hand doesn't necessarily lead to the most efficient outcome. Private markets can't provide the socially optimal quantity of public goods, such as parks, streetlights, education and national defense, because the nonrival, nonexcludable nature of these goods interferes with the supply-and-demand mechanism that drives markets. Competitive markets rely on scarcity to drive up prices and draw forth suppliers. But if one person's consumption of a good doesn't diminish another's, scarcity can't play that vital role. And a person who can't be excluded from consuming a public good can "free ride" by letting someone else pay the price. Markets fail in such situations, but governments can address this market failure by producing those goods publicly.

This distinction between public and private goods provides a useful framework for establishing the appropriate role of government, and in particular the power of eminent domain, in promoting the economy. Discriminating between the two types of goods also informs understanding of the public use requirement set forth in the Constitution. Under the narrow definition of public use, government may seize private property if the public literally uses the redeveloped land, or if it serves the community at large. This principle comes very close to the economist's concept of a public good. The theory of optimal public expenditure was not well developed until the 1950s, but we think that the concept of public goods and the failure of private markets to provide enough of them capture the essence of the narrow definition. The exercise of eminent domain to take private property for public use helps to correct this market failure by getting around the holdup problem.

Now consider the broad definition of public use as a justification for condemnation: an activity that provides some incidental benefit to the public without necessarily contributing to the welfare of the community at large. This principle is much less tightly linked to the concept of a public good. And the Kelo decision completely breaks the link to public goods and the commonweal, allowing property to be taken from one private citizen and given to another to grease the wheels of commercial development. Hotels, shops, offices, condos and the like are unequivocally private goods.

Although proponents of condemnation as an economic development tool assert that creating jobs and raising additional taxes serve a public purpose, there's no evidence that government intervention in private markets—influencing the location decisions of companies by providing them cheap, condemned land, for example—leads to better outcomes. Indeed, an overwhelming amount of evidence suggests just the opposite.

Unintended economic consequences

The fate of the Poletown neighborhood in Detroit and of merchants in downtown Cincinnati demonstrates that redevelopment aided by eminent domain often doesn't turn out as city officials envisioned. In 1981, the City of Detroit demolished over 1,100 buildings, including 140 businesses and three schools, at a cost of over $200 million to clear the way for a new General Motors manufacturing plant. The city expected the facility to employ 6,000 people and lift the economic fortunes of the Poletown neighborhood and the East Side. But the plant never employed as many people as GM promised it would,¹² and what remained of Poletown went into decline. Today, vacant and burned-out buildings line the area's once busy commercial strip.

Likewise, the City of Cincinnati's attempt to use eminent domain to pave the way for an upscale department store downtown had unintended consequences. In the late 1990s, in the course of a complicated land swap undertaken to accommodate the Nordstrom store, the city bulldozed several small businesses. But Nordstrom ultimately declined to build on the site, and the city eventually converted it into a municipal parking lot.¹³ There are plenty of other examples across the country of condemnations that yielded questionable economic benefits.

Local government officials, real estate developers and others who see genuine public purpose in takings for private development point to condemnations that did yield expected returns in new jobs, increased tax revenue and improved public services and amenities. But how much of this economic return can truly be attributed to the use of eminent domain? The key question is whether the development would have occurred without government intervention.

We suspect that in many instances, the development would have occurred without the use of eminent domain; the developer would simply have been obliged to pay a higher price for the land than that assessed by the condemning authority. So using eminent domain results in a net gain for the developer and a net loss for the landowner, without changing the course of development. And in cases where a government taking did facilitate economic development that wouldn't have happened otherwise, economic theory and empirical evidence tell us that resources were misallocated. Would GM have built its Poletown plant if the City of Detroit had not literally cleared the way? Probably not. In hindsight, the plant should have been built somewhere else or—considering the automaker's travails since the 1980s—not at all.

Beyond the inefficiencies that stem from interfering in free markets, the unrestrained use of eminent domain also threatens to undermine private property rights, the bedrock of a well-functioning economy. The work of economists Douglass C. North¹⁴ and Hernando de Soto¹⁵ has shown that economic incentives, based upon individual property rights, are essential for economic growth.

The Supreme Court should end takings for private development

The bottom line? The systematic use of eminent domain to take property from one private entity and give it to another with the aim of promoting economic development is counterproductive. A strong economic case can be made against the broad constitutional reading of public use and, in particular, the Supreme Court's endorsement of economic development as public purpose in Kelo v. City of New London.

The Kelo decision ignores the critical distinction between public and private goods and fails to consider the implications of allowing government to take someone's property for commercial development. As a rule, state and local governments should resist the temptation to intervene in private markets through the power of eminent domain unless the taking is clearly for a public good, that is, a nonrival, nonexcludable good that benefits the community at large. Wielding the big stick of eminent domain as it was wielded in New London inhibits rather than fosters economic development.

We recommend that the Supreme Court reconsider its Kelo decision at the earliest opportunity, perhaps in response to new federal or state legislation reining in the use of eminent domain for private development. A high court ruling strictly limiting the takings power to true public uses would serve the economic interests of all Americans.

* The authors wish to acknowledge the invaluable assistance of V. V. Chari, an economics professor at the University of Minnesota and an adviser to the Bank. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

Endnotes

² U.S. Const. amend. V.

³ Poletown Neighborhood Council v. City of Detroit, 304 N.W.2d 455 (Mich. 1981).

⁴ Dana Berliner. 2003. Public Power, Private Gain. Castle Coalition.

⁵ John-Thor Dahlburg. "An Eminent Domain High Tide." Los Angeles Times, Nov. 29, 2005.

⁶ Kelo v. City of New London at 2665.

⁷ Kelo v. City of New London at 2670.

⁸ In 1919, the Swedish economist proposed a method of financing public goods that is known today as the Lindahl equilibrium.

⁹ R. A. Musgrave. 1959. The Theory of Public Finance. New York: McGraw-Hill.

¹⁰ Paul A. Samuelson. 1954. The Pure Theory of Public Expenditure. Review of Economics and Statistics 36 (November): 387-89.

¹¹ Samuelson at 387.

¹² In 1986, GM laid off 2,500 workers who had been assembling Oldsmobile, Buick and Cadillac cars at the plant.

¹³ Robert Anglen. "Nordstrom Site to Become Parking Lot." Cincinnati Enquirer, Nov. 24, 2000.

¹⁴ Douglass C. North. 1981. Structure and Change in Economic History. New York: W.W. Norton.

¹⁵ Hernando de Soto. 1989. The Other Path: The Invisible Revolution in the Third World. London: I.B. Tauris.