David Friedman recently wrote “One reason to respect natural rights is that it is a good thing to do, another is that respecting them can be expected to produce a healthier, wealthier, and happier world than violating them.” It is in that spirit that I approach the issue of this symposium: since other authors have and will comment more extensively on what is right and good and just with regard to natural resource ownership, I will comment on what sort of natural resource property rights regime leads to a world that is healthy, wealthy, and happy.
To me, the value of arguing from economic efficiency is twofold. For one, my own moral intuitions tell me little about what is a good and just distribution of land or what it should mean to own land – such issues, in my mind, are best informed by utilitarian calculus. Secondly, and in light of the first point, some authors have suggested that personal land ownership is not only unjust but also economically inefficient, employing an argument along the lines of 19th Century American economist Henry George.
Georgism and the Land Value Tax
Earlier today on BHL, we had George expert Fred Foldvary defending the land value tax from an economic efficiency perspective. Foldvary is a leading “neo” Georgist, adapting George’s ideas to the post-marginal revolution age. One of Foldvary’s most salient points is that the existing literature on public finance does not directly contradict the George plan. As he said today, “Public finance theory prescribes land rent as an efficient source of public revenue.”
That said, public finance theory is behind the curve. To remedy this, Bryan Caplan and I have a working paper criticizing the land value tax using an idea from information economics, search theory. Georgists look at the pricing strategy of landowners and see nothing but inefficiency: pricing in excess of opportunity cost, with landowners laughing all the way to the bank. What George and his admirers have missed is not entirely intuitive: while the price of natural resources may indeed be greater than marginal cost, suggesting inefficiency, what appears to be an economic rent is more appropriate called a quasi-rent.
Since in the long-run, no industry can earn anything but the normal rate of return, quasi-rents are necessary incentives for sunk-cost investments, like innovation. In our model, we call the sunk-cost investment “search,” as in the search for natural resources. Certainly, we best incentivize the discovery of natural resources by assigning ownership rights in these resources. But search is costly. For context, the current amount spent by the world’s five largest oil firms represents about 8% of their total operating costs, with spending on exploration increasing steadily since 2005. The largest oil company, ExxonMobil, spent $5.6 billion on exploration and capital projects. Exploration among the next 20 largest private held oil and natural gas providers has been steadily in-creasing since 1998. Aside from oil, mineral exploration costs have been rising rapidly over the past decade and were nearly $18 billion in 2011. If marginal cost pricing was enforced (meaning the oil companies could only charge the cost of extraction and distribution), exploration would cease to be a profitable enterprise. The effect of a Georgist land-value tax would be to move closer to marginal cost pricing (the resources, once discovered, are part of the land’s unimproved value). The only incentive to search is whatever amount of “unimproved value” the landowner can keep post-tax.
The clever Georgist will now respond that perhaps the natural resource discovery is an improvement and should not be taxed, posing no problem for the efficiency of an LVT. In fact, Foldvary recently commented on BHL:
“The economic meaning of land is natural resources, and these activities are labor and capital goods. The value added to a site from exploration is a capital good, not the original natural resource. Hence their critique is based on a fallacious meaning of ‘land.’”
But the sunk-cost investment could also be in the form of market research or trial-and-error. The entrepreneur seeks to create a market and provide a good where none existed before. There is no value to the land other than in what can be imagined to be done with it – if what we have used is a fallacious version of land, then there is no meaningful economic concept of land apart from capital goods (which is precisely Frank Knight’s point in his 1953 critique). Some of these things may seem obvious, particularly from a short-run perspective. But progress is made by finding non-obvious uses for what we have; otherwise we are left in stagnation.
An illustrative example: say an undeveloped lot near a residential area is valued at $x, the sale price at auction. The new owner, an entrepreneur, has local knowledge and believes that the lot is a good place for a business. He canvasses the neighborhood and decides to build a restaurant serving delicious BBQ sandwiches. He believes he has a solid chance of running a successful restaurant, so he takes the risk and embarks upon the project. Ten years later, the restaurant turns out to be a success. Sadly, the restaurant burns to the ground in a freak conflagration. The rubble is cleared and we are left with an empty lot. But is it the same lot as before? Should it be valued at $x? Now, everyone knows a successful restaurant could be built here, before, no one knew. The “unimproved” value has changed. For that matter, the value of nearby lots is likely to have changed as well. What happened to the value of big commercial lots in semirural areas after the first successful Wal-Mart?
Land development, like invention, might also be incentivized through the awarding of prizes. Ownership is only one way to create this incentive, but it seems the most appropriate, because it continually provides incentives to develop and improve land to its highest-valued long-term use.
The central lesson is that the Georgist distinction between improved and unimproved land is illusory. The idea of land rent as a surplus – gains beyond costs – is an economic sophism. Like other goods, there is value not only in what is produced but also in the knowledge of what to produce. In the long run, there are no “economic rents,” just return on initial endowments, effort, and luck.
Long-Run Effects of Land Taxation
That we have established land as not fundamentally different from other goods is perhaps not enough to say there’s an efficiency argument for low land taxes. If we are going to tax something, why not the value of land short of obvious physical improvements, which seems fixed in supply at least in the short-run?
Tax system designers constantly face trade-offs between short-run and long-run gains. In the shortest of runs, everything is fixed in supply. The problem is that people respond to taxes by substituting one sort of behavior for another until every endeavor once again earns the normal rate of return. While not too many would quit their job today, or this week, if they found out that their income tax rates had climbed to 90%, in the long-run folks will consume more leisure, or switch to jobs with more non-taxable benefits (like being an academic?), and this will result in lower economic growth.
The long run effects of land tax increase are similar. In the short-run, folks continue as they have. But now, thinking of or searching for new uses for land earns below the normal rate of return. Sure, the empty lot might be perfect for a mall, but why bother finding out? Once you build the mall and prove it can be a success, the value of the land itself will increase. But you had the idea, did the research, and took all the risk, how do you get compensated for that? The same could be said for a large exploratory drilling project. In the long-run, land taxes disincentivize land ownership and development.
The tax tradeoff between short and long run gains results in a precarious equilibrium in a game between the taxing authority and the citizens. Individuals usually engage in productive activity with the expectation that they benefit from the product. They may know that the government can defect at any time, but they trust that they will not. This regime stability is the high-trust equilibrium that the developed world mostly enjoys. There is a second equilibrium where people constantly suspect that the government will defect, so they produce little, or go to the black market.
Land and natural resources are very important endowments, especially in a world with rapid population growth. It is imperative that the price system functions well; an unanticipated shortage or rapidly rising prices (due perhaps to a drastic change to the world’s tax codes) might have disastrous consequences. For the trend of decreasing scarcity and increasing population to continue in true Simonian fashion, we need a stable system of property rights which engenders innovation. This includes property rights to land.
Foldvary, Fred. (2005). “Geo-Rent: A Plea to Public Economists.” Econ Journal Watch 2(1): 106-132.
Knight, F. H. (1953). “The Fallacies of the ‘Single Tax’.” Freeman. August: 809-811