What Is Economic Rent?

I had an interesting question from a Cycles, Trends & Forecasts subscriber this week.

Take a look:

‘Catherine, I bought my house here in South Melbourne in October 1981.

‘It cost me $ 55,000, a 2 bedroom weather board, north yard, free standing with side gateway, all in good order.

‘I could sell it today for about $1,300,000 $55,000 subtracted from $1,300,000 leaves the sum of $1,245,000.

‘Is this sum what you mean by economic rent, I was sleeping a third of that time.’

‘Donald’

Donald’s question is a good one, and as president of Prosper Australia — Australia’s oldest economics organisation — I feel it’s one that needs to be addressed.

Afterall, Prosper Australia advocates taxing away all economic rent, while also untaxing labour income and productivity!

Thus, falling in line with the advocacy of the late 19^th century Economist Henry George.

Clearly, there’s a lot of confusion regarding what exactly economic rent is. And I suspect Donald’s reference to being asleep one-third of the time is in relation to a quote I penned in a recent article that stated:

‘Landlords grow rich in their sleep without, working, risking or economising.’

A quip coined by the late John Stuart Mill (1806–73).

The quote is still applicable today, of course.

After all, over the boom years of the housing cycle, many will have made more from their real estate going up in value over a year than they would’ve working for a living!

Even the dramatic falls in capital city median values witnessed over 2022 haven’t wiped out the gains from the post-pandemic boom.

In economics, this gain in land price is termed ‘economic rent’.

The definition can be summarised as the unearned profit that comes from owning a resource, monopoly, natural scarcity, or anything else that gifts a windfall — one that’s not ‘earned’ from toil, risk, or enterprise.

Rent-seeking can take on many forms, such as patents and government licences, for example, which cripple competition from smaller industries and produce an unfair advantage.

But undoubtedly, the one that gifts the greatest gains over the cycle always comes from owning the rights to land.

The increase in land price results from several things, including an increase in the working population moving into a region and the development of government-funded infrastructure.

UK Economist Fred Harrison coined the effect of infrastructure spending on the housing market as the ‘Law of Economic Absorption’.

The late US economist Mason Gaffney took it one step further with the acronym ATCOR — ‘All Taxes Come Out of Rent’.

The term ‘rent’, of course, refers to ‘economic rent’ — the earnings from owning land.

As stated above, both are central to the land theory of Economist Henry George.

The Law of Economic Absorption and ATCOR may sound a bit complicated, so let me try and put it in simple terms.

It’ll help you understand how the economy works and why we have a property cycle at all.

And it will help answer Donald’s question!

Despite great technological advances, it’s always the owners of the locations that capture the most wealth.

This includes access to the electromagnetic sphere for telecommunication, etc. Noting that ‘land’ in economics refers to all natural elements — minerals included.

Well-facilitated land is always short in supply and high in demand.

Therefore, as society gets richer, the land market in the areas people most want to live is bid up in price.

This is why Henry George’s 1897 magnum opus was called Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth — The Remedy.

No matter how much progress we have, while the owners of land are allowed to reap the gains, poverty must always exist.

In the housing market, labour taxation takes some of those riches before they reach the land market — reducing a buyer’s budget.

Therefore, it follows that the removal of labour taxes (note: 90% of current taxation falls on labour) naturally washes up into higher prices for real estate.

If we were to capture this rise with a land tax, then in theory, it would leave the resulting rise in the economic rent of land ‘just’ enough to replace the forgone revenue.

To put it plainly: Get rid of labour taxes, and land prices rise!

But equally, if we get rid of taxes on buildings, land prices rise.

Removal of stamp duty (as the property lobby desires) and land prices rise.

You get the idea. In other words — All Taxes Come Out of (land) Rent — ATCOR.

The only way to counter this is with a broad-based land tax that takes the gains before they’re pocketed.

Something the FIRE (Finance, Insurance, and Real Estate) sectors and our property-owning governors will never permit.

They would rather a labour tax.

Your labour tax bill is the biggest bill you pay in your lifetime.

Still, this knowledge of ATCOR is how you can get all your income taxes gifted back to you.

A chap in the UK, Don Riley, documented how he did this in his book Taken for A Ride: Trains, Taxpayers and the Treasury (2001).

Don worked in the computer industry for 40 years.

He duly paid his taxes to Her Majesty’s Treasury throughout that period.

However, when the millennium came, as he puts it, ‘a miracle happened!’.

The government returned every penny he had ever paid in taxes and more. How?

Britain’s taxpayers generously funded an extension to the Jubilee line (JLE) on London’s Underground rail network.

Two of the stations were located close to Don’s office properties.

That raised the value of his properties significantly.

In fact, the £3.5 billion invested in the JLE by taxpayers caused the price of houses near the line to soar by an estimated £14 billion upon opening.

Don’s calculation showed the rise in value for his two properties gifted back all the tax payments he had made over that entire 40-year period.

Thus, if we tax away those gains annually, land prices would fall.

Which brings me to a Twitter thread I interacted with recently, in response to Peter Tulip’s (Chief Economist at Centre for Independent Studies) bold assumption that land taxes do not affect the cost of accommodation:

A tax on land absolutely impacts the value of land.

Something highlighted prominently in the Henry Tax Review (the government-commissioned review of the country’s tax system, led by Treasury official Ken Henry back in 2010).

Just as I tweeted above, the report concluded:

‘When a land value tax is introduced, the existing owners of land bear the burden of the tax as a reduction in land values.

‘Potential buyers of land will reduce how much they are willing to pay for land by the value of the expected land value tax payments.

‘That is, the value of land reflects the future after-tax earnings on land — with a tax in place, people will buy land only when they can pay less for it.

‘Potential buyers will expect to get at least the same risk-adjusted return from land as they could from alternative investments.

‘That is, land value tax reduces the value of the land to equalise the after-tax return to land with the return to other investments.

‘This means that land tax does not distort investment decisions.’

But back to Donald’s question.

What is the economic rent on his block of land?

Well, it’s not quite what Donald concludes when he calculates the capital gain.

Rather, the uplift in the unimproved land value (represented by the current land price) is Donald’s capitalised economic rent accumulated on the site without being taxed via an annual land tax.

However, to be totally accurate, economic rent in application is simply the annual land rent of the site.

The annual increase in land value is quite different from the site’s annual rental value or economic rent.

This is because a capitalisation rate needs to be applied to the annual rental value to arrive at the annual increase in the site’s value.

That may sound a little long-winded, but in practice, it’s an acknowledgement that a percentage tax taken each year would reduce land’s price — and thus tax away its economic rent.

Hence, the Henry Tax Review concluded that a 1% broad-based land tax on a block of land worth $600,000 (assuming an interest rate of 5% and land that returns a rental income of $30,000) would reduce its value to $500,000:

‘For example, a land tax rate of 1 per cent would see the value of land fall to $500,000; that is, equivalent to the present discounted value of the tax liability of $100,000.

‘Any new buyer of the land will receive a rental income of $30,000, out of which a tax of $5,000 would be due.

‘But because they only paid $500,000, they still earn an post- tax return equivalent to the market return of 5 per cent (that is $25,000).

‘The purchaser is effectively compensated for the tax payments by the fall in the price of land.’

The Henry Tax Review is still available online.

The chapter devoted to land taxation is well worth a read for anyone interested in the subject, which should include anyone interested in investing in land!

After all, an understanding of how the various property taxes affect the land price is essential for understanding and being able to accurately value real estate for purchase, investment, and development. As well as having a grounded knowledge of how policy changes (such as stamp duty to land tax) affect the price of land.

Best wishes,

Catherine Cashmore,
Editor, Land Cycle Investor