A Matter of Economics

A discussion paper critical of the use of the term ‘economic rent’ in contemporary economics.

Summary

Argument for the overt taxation of land value in lieu of other taxes, a live issue not so long ago, is now largely disregarded by economists, politicians and commentators. Only the capital gains realised upon betterment excite much attention. One explanation may be found in evolved economic theory where land value has become the sum of two components – the opportunity cost of appropriation, i.e. a ‘supply’ price, and an enhancement, named ‘economic rent’, due to specific inelasticity of supply for current usage. This partition leads to parallels of formation being drawn between rent, wages and interest, so that economic rent is found in wages and interest as well as in (whole) rent. A case, in arguable principle, for taxing economic rent, as defined, in all three factors falls at once in the face of obvious impracticabilities. It is here submitted that the powerful role of land value in the economy has been obscured by this digression. The case for the taxation of undifferentiated land value is reasserted.

Introduction

1. Economists of the nineteenth century would scarcely recognise their subject in the late twentieth. Theory has overtaken theory as economic systems have stubbornly refused to conform in anything but the relatively short term. Manipulation or stifling of normal economic behaviour invariably generates its own tiers of malfunction.

2. In an industrial society, as in an agricultural one, the three `classical’ factors of production – land, labour in all its forms (including entrepreneurial initiative), and capital – are still distinguishable, although the economic difference between land and artefacts made from land which constitute capital is often lost when the two are compounded as ‘property’.

3. In a free market economy, a market-determined share of the proceeds of production flows to each of the factors engaged, effecting a wealth distribution regime. This paper looks first at the fundamentally limited powers of labour and capital funds employed to determine their wages and interest respectively, and points, like the classical analysis, to the whole rent of land as taking the true surplus of production.

4. It is widely assumed that market forces inevitably lead to large disparities in incomes and doom the system to periodic instability. At the same time, the chronic shunning of the relevance of land value and its appropriation keeps the door closed on a challenging area of investigation and research.

Labour and wages

5. All kinds of work activity, by hand or brain, directed towards the production of goods and services, are `labour’ and all kinds of remuneration to labour are ‘wages’.

6. Wage-earners aim to sell their labour at the highest rate they can get in their particular job markets (tempered, possibly, by private domestic and social considerations); employers to hire at the lowest. The prevailing rate of remuneration in any instance represents the point where the variables of supply and demand have arrived in balance.

7. Labour markets include within their panoply of employable abilities those of people who are ready to change jobs, are unemployed, are emerging from study and training – students and school-leavers, etc. – or who are wanting to re-enter employment after an absence. In a given locality, a shortfall in the supply of labour of one kind tends to be met by the offer of a wage just high enough to lure suitable and sufficient workers away from, or out of, other employment. Alleviation of the shortage, possibly aided by workers being drawn from further afield or by the availability of a suitable alternative product, puts an end to the wage rise. With time, the old level may well be restored.

8. Thus wages tend to find their own levels and labour has no power to demand more than the going rate for the job. Neither can it claim a wage increase out of the gains of increased productivity other than by offering skills of higher market value or by prior agreements on pay and productivity, i.e. on profit sharing. Collective coercive action may add to the wages of some, but labour as a whole cannot in real terms `pay itself too much’.

9. Conversely, employers have no compulsion to pay more than the going rate for a skill or aptitude. That is none the less true if, in some circumstances, they might pay a premium for exceptional ability. Employers are, furthermore, constrained from paying more than is necessary by the imperative to keep unit cost to the minimum. Unilateral price rises would, all else being equal, be self-defeating.

Capital and interest

10. Capital as a factor of production comprises fixtures – buildings, plant, machinery, and all that goes with them – and materials in course of manufacture – stocks of raw materials, materials in process and stocks of finished goods. All are derived essentially from the application of labour to natural resources, i.e. to the factor ‘land’, from which they are thus physically and economically distinct.

11. Interest has to be accounted for, ultimately out of the proceeds of production, as part of the cost of the use of capital. Its market rate at any time is determined at the point of equilibrium between the demand for liquid assets and their supply. In addition the provider of capital funding normally requires, competitively, a percentage rate commensurate with the judged riskiness of the undertaking. History suggests that, in the absence of government intervention, a low-risk real interest rate would not be more than about 5%.

The entrepreneurial return

12. This is the higher reward for innovation, invention, efficiency, foresight, etc. which give competitive advantage to the originator. So long as the advantage is maintained, e.g. by licence or by secrecy, continuation of the reward is safe from price competition. Sooner or later, however, knowledge and know-how tend to become diffused and available.

13. Enhancement of income due to an individual entrepreneur’s own achievement can be reckoned as a wage increment. The profits of large corporate investment in, e.g. property development, or economies of scale, or research and development, comprise to a considerable extent a return to capital (and hence to management, shareholding and reserves) for the risks taken. Transactions in the commercial property market are generally aimed at land value for profit, by way of rent reviews or change in use.

Land and rent

14. Charity apart, labour and capital have their costs and therefore their prices, in wage and interest terms respectively.

15. In contrast, land has no cost of production and if there were an unlimited supply of it wherever and whenever it was wanted then, short of expropriation by the more powerful, no one would have to pay anyone anything for its use. But the land provided by Nature is both finite at the point of demand and not transportable.

16. The level of demand for the fixed supply of land at any particular location gives the land its value, as revealed by competition between prospective users. Any elasticity of supply that it may be said to have lies only within the balancing of competing demands for different uses. Increased production per unit area of land may be initiated by increased capital concentration, most conspicuously by building upwards so as to have more floor space.

17. In rental terms, the value of a site is given by the highest payment that could be procured per annum for the exclusive right to certain, or all, of its beneficial attributes at optimal development in line with Planning consent. Commercial rents of developed sites reflect, for the time being, existing states of development and fluctuations in demand for floor space; less than optimal development may obscure, but does not diminish, true site value.

18. In production terms, site rent is a first charge, to be met out of the difference between aggregate revenue and all labour and capital costs.

Rent vis-a-vis ‘economic rent’

19. Whilst the quantity of land is everywhere undeniably fixed, in present-day economic theory the possibility of alternative uses constitutes ‘supply’ for any particular purpose. Supply for one kind of use rather than other kinds follows its own supply vs rent curve to the point where supply and demand meet.

20. Rent is said to have two components. One is its transfer, or opportunity cost, which is the rent of the land in its next best use, the rent foregone. The other, the difference, is an amount attributable to the scarcity, or inelasticity of supply, of the land in its particular location for its present, or intended, use. A site at the external margin for a particular kind of use yields only its transfer cost. All other sites yield economic rent in addition, depending on location and/or fertility. The claim of economic rent in securing best use of land is the same as that of economic rent plus transfer cost, both as defined, i.e. whole rent.

21. The rent of land as a whole is, by this argument, entirely economic rent since land has no supply price and therefore no transfer cost. It translates into transfer cost, an opportunity cost in other words, insofar as appropriation of land value imposes a supply price.

22. This theory proceeds to find economic rent, as a surplus to transfer cost, in wages and interest also. Its application to wages is along the following lines.

23. Individual wage-earners [plots of land] are attracted out of existing employment [usage] into another kind of employment [usage] by the offer of a higher wage [rent]. Supply of labour [land] for a particular purpose is thus a process of change from other kinds of employment [usages] to the better one on a rising supply vs wage [rent] curve until the particular demand for labour [land] is met. The wage [rent] finally paid for a particular kind ofemployment [usage] at a given time and place is theoretically the same for all wage-earners [plots of land] engaged in that employment [usage], though their opportunity costs differ.

24. The wage increment gained by the wage-earner in this supply process is said to be economic rent, while the wage foregone, his last and next best, is an opportunity (transfer) cost.

25. Funds, funding, investment and interest rate could replace wage- earners, labour, employment and wage, respectively, in para. 23, with interest rate taking account of the particular riskiness of an undertaking.

“Economic rent” – a snare and delusion?

26. When economic rent is examined as a ‘dynamic’ as well as a ‘static’ phenomenon, the shortcomings of the theory appear.

27. As defined, economic rent appears vaguely as ‘betterment’ in political and Planning vocabularies; it does not necessarily imply optimal use of land. It is then widely regarded as a fortuitous, windfall, gain. The wage-earner, upon change in employment to a better paid job, is unlikely to regard his wage betterment in quite the same way.

28. His bias would be justifiable. He would know of the competition for jobs in his particular vocation and would sense the market forces of supply and demand in operation. The supply of labour for any particular kind of job is strongly influenced in the longer, if not the shorter, run by its transferability from one place to another and by opportunities for education and training. Except in instances where a few, because of the scarcity of their particular abilities and because of the willingness of others to pay for them, are able to maintain abnormally high wage rates, the upward curve of a wage against labour supply is restrained.

29. Interest rates have comparable limitations.

30. Demand for the production of goods and services by a consumer population on a fixed total amount of land drives rents upwards by competition towards the best possible use of each site, in equilibrium with rents and usages of all other sites. Interchangeability between one kind of use and another is part of that process. Rent commands the excess of revenue over all labour, capital and entrepreneurial costs.

31. If there were no scarcity, there would be no rent of land; competition would tend to bring about optimum distribution of sites between usages, with optimum concentrations of labour and capital on each site. Rent is provided by the increase in productivity of labour and capital, in terms of land area, due to their increased concentration on scarce land. In Ricardian terms, it is provided by the difference between the average productivity of a site and productivity at the margin, external and internal, of production.

32. Labour (other than entrepreneurial) and capital have no claims on productivity.

33. The theory of parallels between wages, interest and rent in terms of opportunity cost and economic rent does not concern itself with the dynamics of wage and interest determination on the one hand and of rent on the other. It appears to have little economic significance beyond consolidating the legitimacy of a supply price for land.

34. It is submitted that there is a case for a reappraisal of the theory of differential but parallel surpluses in all factor returns. Is not rent of land the one, true, surplus?

35. When rent or, more precisely, land value at optimum permitted development is considered as a source of public revenue its important role in the economy becomes more apparent.

Taxation and land value

[Payment in services or in kind to the Crown in return for land holding was for centuries part f the social order, supplemented in the course of time by various indirect taxes. The first Income Tax was a means of financing the Napoleonic Wars and was re-introduced by the Income Tax Act of 1842, again as a temporary measure though it became permanent.]

36. Economic theory having defined ‘economic rent’ in the abstract and generally as (to quote) ‘the surplus of satisfaction over effort’, an inference is that surpluses might be taxed away without discouraging productive effort. Obvious impracticabilities have stalled further, constructive, thought in that direction.

37. If economic theory and political acuity were to concentrate on the surplus that is land rent, and not only a fraction of it, its unique advantages as a source of public revenue would be exposed. Importantly, rent is to be taken as the market value (para. 17) of all land, whether currently used, under-used or derelict.

38. Salient points in the case for the overt taxation of land value are as follows.

39. A first contention is that price levels of goods and services, wages and interest rates would, none of them, change in direct response to an annual tax on land value. Rents, already at the highest the market will bear, cannot rise.

40. Some positive, beneficial, consequences of the tax, when properly applied, are reasonably predictable.

For examples, it would :

 

 

• be impossible to evade (a point made more pertinent with the advent of electronic money).
• be relatively simple to understand and to administer.
• relieve taxes on employment.
• reduce and ultimately eliminate the withholding from use and serious under-use of land purely for speculative gain, or through indifference.
• stimulate employment, with less state welfare dependency, by virtue of the last two points.
• reduce the pressure for building into neighbouring rural areas, by efficient use of urban land.
• avoid over-accumulation of capital due to artificial land shortage.
• divert investment funds away from speculative absorption in the land market and into productive use, thereby promoting the end of the over- capitalised boom and under-capitalised slump sequences.
• through changes in the pattern of wealth distribution, enable more wage-earners, not rent-receivers, to own capital.
• be a way of spreading rises in land value due to private and public enterprise back amongst the community.

41. It has been the aim of this paper to present a view of some basic principles of economic theory as concisely and clearly as possible. The background commentary is therefore simplified and much detail omitted. Ethical aspects of competition and ownership have been excluded for present purposes.

42. The majority of politicians nowadays fail to grasp the significance of land value and its appropriation in the economy or, if they do, they are silent. Could `fear’ be truer, for some, than `fail’. And economists too?

Acknowledgments. The writer gratefully acknowledges helpful comments already received while absolving those who made them from any responsibility for errors of understanding, omissions, etc. which may remain.

Works consulted include:

Jack Harvey, ‘Urban Land Economics’, 3rd Edn., 1992, Macmillan.
D J Browne, ‘Economics: theory and practice’, 2nd Edn., 1989, Edward Arnold.
Sir Dennis Robinson, ‘Lectures on Economic Principles’, 1963, Collins, The Fontana Library.

[Footnote : Several enquiry committees concerned with local government finance between 1952 and 1976 did not find in favour of site value rating, but it should be well noted that their deliberations were all conducted when one or other of a series of land reform Acts was in force. There were provisions in these Acts which clouded, or even vitiated, the issue. (see ‘Essays in Land Economics’, V.H.Blundell, 1993, E.S.S.R.A., 177 Vauxhall Bridge Road, London SW1V lER.)]