It is widely accepted that the Henry Review will recommend a Resource Rent Tax when it is released next Sunday. I’ll be talking about that at the CIS Tax Forum. In the meantime here is a discussion about the concept of rent and the general principles of taxing rent.
Economic rent is usually defined as being a return over and above the minimum return necessary to keep a factor of production in employment; in other words what economists refer to as a ‘super-normal return’ or an ‘economic profit’. Rent was a very important component of classical economics – being the return to land, one of the three factors of production; the other two being capital and labour.
Land has a very specific meaning in this context. Land is the bounty of nature – David Ricardo referred to ‘the original and indestructible powers of the soil’. Fred Foldvary writes that economic land ‘includes all natural resources and natural opportunities’. Land is a bounty of nature, where nature is defined as ‘all resources prior to and apart from alteration by human action’. In order to reinforce the connection between land and rent, Foldvary has introduced the term ‘geo-rent’. To the extent that only land can give rise to rents this is a useful term to differentiate the economic understanding of rent, from the everyday understanding of any payment to acquire use of an asset, but not ownership. The term ‘rent’, however, does not only apply to land; rents can occur whenever supernormal returns are earned.
Rents can occur when supply curves are inelastic. George Stigler explains
Any productive factor in inelastic supply receives a return that partakes in some measure of a rent. Almost every piece of capital goods – a building, a machine, a tool – may have an inelastic supply in the short run, and then its return is called a quasi-rent because of its similarity to the rent of land in the classical theory.
There are three important points to note in Stigler’s comment. First a characteristic of rent is an inelastic supply curve. Second, to the extent that rent does exist it is likely to be temporary. Alfred Marshall first introduced the notion of a quasi-rent to describe temporary super-normal profits in the short-run before factors of production can be re-organised into a long-run equilibrium. Third, rent is very much associated with the classical school.
There are many good things in classical economics that should be preserved, especially in the area now known as macroeconomics, but the idea of rent is not one of them. Rent essentially has its origin in the classical theory of value. If we employ a labour theory of value, or a cost theory of value, it is difficult to understand why the bounty of nature has any value at all. Rent becomes a device to explain why some resources have value when no labour-power has been exerted to create that value. Joseph Schumpeter sums up the argument very well.
If we do insist on a labor-quantity conception of value, or even on a theory of value that rests on real cost in the sense of disutility and abstinence, and accordingly wish to eliminate requisites of production that are costless in this sense, the device does its duty.
Rent serves a purpose in explaining phenomena that the classical theory cannot otherwise explain; land has the ability to produce goods of value despite the lack of human intervention. It is only after the marginal revolution in the 1870s and the introduction of subjective value that rent can be explained. Modern economists understand why land with different fertility and soil quality is valued differently. It turns out that land is not an homogenous asset and a device called ‘rent’ does not need to be introduced to equalise returns from very different assets. As Ludwig von Mises explained
It does not astonish the farmer that buyers pay higher prices and tenants higher leases for more fertile land than for less fertile. The only reason why the old economists were puzzled by this fact was that they operated with a general term land that neglects differences in productivity.
Mises differentiates between two ideas contained within Ricardian rent theory. First the notion of differential rent; some land is worth more than other land. This he believes to be correct. Second, the idea that there is some residual value in land known as rent – this he rejects.
The reason why the price of Burgundy is higher than that of Chianti is not the higher price of the vineyards of Burgundy as against those of Tuscany. The causation is the other way around. Because people are ready to pay higher prices for Burgundy than for Chianti, winegrowers are ready to pay higher prices for the vineyards of Burgundy than for those of Tuscany.
The value of land is determined not by some notion of rent; rather it is determined by the ability of an entrepreneur to employ that land to generate a good or service that can be profitably sold on the market. Land that can be employed more productively is more valuable than land that is less productive. Similarly employees who are more enthusiastic are more valuable than those who are ‘work-shy’ – at a given wage the former are a source of rent to their employers.
The taxation of rent has some very desirable theoretical characteristics. First, the incidence of the tax is clear – it falls on the owner of the land. Second, it has no deadweight losses associated with it. Third, the tax can be easily justified by appeals to fiscal illusion.
The first two benefits can be traced back to Adam Smith.
As it has no tendency to diminish the quantity, it can have none to raise the price of that produce. It does not obstruct the industry of the people. It subjects the landlord to no other inconveniency besides the unavoidable one of paying the tax.
In modern terms the argument is that rent is an extranormal return and so if and when it is reduced it will have no impact on production. A tax on rent has no behavioural response and so has no deadweight costs associated with it. Smith, however, argued that rent was associated with monopoly, whereas Schumpeter argued that view was wrong. It is clear that Ricardo didn’t think that rent was associated with monopoly. In fact he argued that the reason a tax on rent did not increase prices was due to competition from those producers who didn’t have a supernormal returns and consequently were not liable for the tax. For whatever reason, however, both were of the view that the tax could not be shifted.
The view that land tax could not be shifted from the landlord remains popular. Public finance textbooks give rent taxation as the example of a tax that cannot be shifted. The legal incidence of the tax and the economic incidence of the tax are identical. The rationale for this view is that the supply of land is fixed and consequently ‘inelastic’. Standard economic analysis indicates that the owner of a taxed item with inelastic supply will pay any tax. In short, a rent tax should reduce the value of land by the extent of the tax. What this means is that the tax is capitalised into the value of the property. The original land owner bears the entire tax burden, and sells the property with the tax burden detached from the property. Future owners simply collect and pay money to the government – but this has no impact on their expected returns. If this view is correct, a tax on rent is an efficient mechanism for government revenue. Even F.A. Hayek concedes, ‘If the factual assumptions on which it were based were correct, … , the argument for its adoption would be very strong’.
When tested those ‘factual assumptions’ turn out to be fragile. I have already shown that the notion of ‘rent’ was a device to explain an anomaly in classical economic theory. Nonetheless, it is worth further exploring the idea of rent as a supernormal return. Neither Frank Knight – famous as one of the founders of the free-market Chicago school – nor Murray Rothbard, disciple of Ludwig von Mises, thought the geo-rent existed at all. Knight had written in 1933, ‘The theory underlying this doctrine is one of the most rudimentary and obvious of all the fallacies ever promulgated in the name of economics’.
Knight’s argument against geo-rent taxation was simple; there is no evidence to suggest that land ownership generates any greater return than an investment in any other asset. In his 1921 classic Risk, Uncertainty, and Profit Knight had argued that the notion of land being in fixed supply was ‘utterly fallacious’.
It should be self-evident that when the discovery, appropriation, and development of new natural resources is an open, competitive game, there is unlikely to be any difference between the returns from resources put to this use and those put to any other.
Unless money grows on trees, nature does not simply provide economic assets – even if money did grow on trees, it would require a labour input in order to pick the money off the trees. In a hunter-gatherer environment nature may well provide some bounty, but at any level of economic activity above hunter-gathering natural produce must be combined with capital, labour, and entrepreneurial insight before economic value can be established. Even hunting requires an investment in skills and human capital. Adam Smith when establishing the notion of rents used the example of collecting kelp to create alkaline salt. The land or the kelp itself did not generate a return; the knowledge that alkaline salts can be derived from kelp and subsequently turned into soap generated the returns. The rent is not inherent within the land itself; it is a return to entrepreneurial discovery. Land is an input into the wealth creation process just as any other factor of production.
In some sense it seems that Ricardo was aware of the difference between land and the produce of land. He indicates that Adam Smith isn’t always consistent in his treatment of rent.
He [Adam Smith] speaks also of the rent of coal mines, and of stone quarries, to which the same observation applies—that the compensation given for the mine or quarry, is paid for the value of the coal or stone which can be removed from them, and has no connection with the original and indestructible powers of the land. This is a distinction of great importance, in an enquiry concerning rent and profits; for it is found, that the laws which regulate the progress of rent, are widely different from those which regulate the progress of profits, and seldom operate in the same direction.
When talking specifically about the rent that attaches to mines, Ricardo makes the argument
The metals, like other things, are obtained by labour. Nature, indeed, produces them; but it is the labour of man which extracts them from the bowels of the earth, and prepares them for our service.
Ricardo comes very close to a modern understanding of value and the importance of entrepreneurship. Yet, as von Mises indicates the classical economists were blinded by their understanding of costs driving prices and were unable to take that additional step.
Rothbard has an entrepreneurship argument too. Land owners perform a valuable entrepreneurial function by bringing productive land into use.
He finds, brings into use, and then allocates, land sites to the most value-productive bidders. We must not be misled by the fact that the physical stock of land is fixed at any time. In the case of land, as of other material goods, it is not just the physical good that is being sold, but a whole bundle of services along with it – among which is the service of transferring ownership from seller to buyer, and doing so efficiently. Ground land does not simply exist; it must be served to the user by the owner (one man, of course, can perform both functions when the land is “vertically integrated”).
As Rothbard points out, there is a large service function associated with selling, or even leasing land and the classical economists, who promoted the taxation of rent, tended to undervalue such functions. Rothbard makes a series of important points in that quote. First he highlights the entrepreneurial function that the classical economists neglected. Second he argues against the notion of inelastic supply curves. Third he points to vertical integration. Government very often makes use of land that it owns for various activities and it seems that is one way it could capture rent, if it existed. This point hasn’t gone unnoticed and many socialists have supported either the outright ownership of land and other rent-producing assets, or the taxation of rents. Armen Alchien and William Allen, for example, argue that government should not own land simply to capture rents as the incentive facing bureaucrats are very different to those facing profit-seeking entrepreneurs.
George Stigler deals with the notion of perfectly inelastic supply curves as an aside. The entire basis of the taxation of rent is that supply curves are inelastic; yet Stigler dispatches this idea in two sentences (emphasis added).
Almost all real economic questions involve a particular use of land – growing wheat or trees, residential subdivisions, national parks, superhighways, and so on. Then the alternative uses of the land are significant, and one must recognise these costs (and, from another viewpoint, the substantial elasticity of supply of land).
The economic arguments to sustain the idea of rent and specifically rent as an efficient tax base are very flimsy.
Israel Kirzner raises an additional point. What external observers may classify as being a rent may well be a cost to market participants.
What is rent, viewing the industry as a single unit, may be a cost, when the industry is viewed consisting of producers of different entrepreneurial skills. An oilfield being exploited by a particular oil company commands a price a small part of which is necessary to withstand the competition of farmers for the land, the rest being necessary to outstrip the competition of other oil companies. This second portion of the price is rent from the perspective of the oil industry as a whole, but cost from the viewpoint of any one oil company.
This observation points to the distinction between aggregates and individuals. In aggregate it may well appear that something called rent exists, yet no individual decision makers perceives this rent when making decisions. Rent is a violation of two important components of modern economics; subjective value and methodological individualism. Actual decision makers would then perceive any tax on rent as a tax on their profit and would behave accordingly – to the extent that Kirzner is correct, any tax on rent must give rise to a behavioural response.
Subjectivity and methodological individualism have very important consequences for our understanding of opportunity cost. Hayek has argued that any explanation of human action must be constrained by the same information and understanding that the decision maker faces; he uses the theory of rent to make this very point. He then generalises, an external observer cannot predict the decision making process of an entrepreneur without a detailed knowledge and understanding of what the entrepreneur knows and understands.
What is true of the theory of rent is true of the theory of price generally: it has nothing to say about the behavior of the price of iron or wool, of things of such and such physical properties, but only about things about which people have certain beliefs and which they want to use in a certain manner. And our explanation of a particular price phenomenon can therefore also never be affected by any additional knowledge which we (the observers) acquire about the good concerned, but only by additional knowledge about what the people dealing with it think about it.
James Buchanan has expanded on this argument to introduce the notion of ‘choice-influencing – cost’. Choices, and the costs associated with those choices, are made on the basis of expectations. External observers cannot know the entrepreneurs expectations, they can only observe ex post outcomes. Buchanan emphasises the argument that accounting costs are not economic costs. Accounting costs are ex post outlays to achieve a decision that has already been made. While accounting data can be used to establish whether receipts are in excess of outlays, they can certainly never establish whether a supernormal return has been earned.
A tax on rent also fiscal illusion characteristics that would make it a populist policy. Fiscal illusion refers to the efforts that tax-collectors undertake to reduce community resistance to taxation and so lower the social costs of tax collection. The idea of fiscal illusion was first developed by the Italian economist Amilcare Puviani and introduced to the English speaking word by James Buchanan. A tax on rent is equivalent to taxing winners. For this reason a tax on rent is popular with those individuals who have social reform agendas – the tax can be used to target ‘undeserving’ winners. The great classical economist John Stuart Mill set out the case for a tax on land.
Suppose that there is a kind of income which constantly tends to increase, without any exertion or sacrifice on the part of the owners: those owners constituting a class in the community, whom the natural course of things progressively enriches, consistently with complete passiveness on their own part. In such a case it would be no violation of the principles on which private property is grounded, if the state should appropriate this increase of wealth, or part of it, as it arises. This would not properly be taking anything from anybody; it would merely be applying an accession of wealth, created by circumstances, to the benefit of society, instead of allowing it to become an unearned appendage to the riches of a particular class.
Now this is actually the case with rent. The ordinary progress of a society which increases in wealth, is at all times tending to augment the incomes of landlords; to give them both a greater amount and a greater proportion of the wealth of the community, independently of any trouble or outlay incurred by themselves. They grow richer, as it were in their sleep, without working, risking, or economizing. What claim have they, on the general principle of social justice, to this accession of riches? In what would they have been wronged if society had, from the beginning, reserved the right of taxing the spontaneous increase of rent, to the highest amount required by financial exigencies?
This is an extraordinary claim – the government can and should tax rent because it is unearned and results from passive investment. Mill’s argument is inconsistent with entrepreneurial action. Again, if true, this argument would be a powerful argument for taxing rent.
As an empirical matter Mill’s observation is probably incorrect. The underlying assumption here is that increases in societal wealth manifest themselves as increases in geo-rent. That implies that geo-rents (and land rents) should either remain as a constant percentage of national income, or even increase as national income increases. Gregory Clarke, economic historian at the University of California, Davis, has shown that English land rents (which by definition include geo-rent) have fallen since 1760. Farm land rents have fallen from 23 percent of national income to 0.2 percent. Over that time period urban land rents have increased in value, but still only constitute 4 percent of national income. Clark argues that this trend is the case in all modern high-income economies. The notion that land owners are the recipients of massive unearned increases in wealth that can be taxed in impunity simply does not accord with the empirical record.
Despite the theoretical advantages to taxing rent, a number of theoretical problems quickly become apparent. As suggested in the previous section, the concept of rent itself is problematic; it may not exist. Even if it did exist, there appear to be some theoretical problems in taxing rent.