A Remark on Ricardian Taxes

A lot of people are skeptical of the idea that a Ricardian tax program on land and natural resources can finance the kind of government we need. I’ve outlined – in some detail – why this isn’t the case but some prominent voices, like Paul Krugman, disagree:

But [Henry George – late champion of land taxes – has] been out of favor for decades, especially in graduate schools. Economists are trained to ignore him. Paul Krugman came to Berlin in 2008, right when the subprime crisis had started to rumble, and I asked his opinion of Henry George. He squinted and tried to remember the name of the book. “Uh — Progress and Poverty I think is the [main text]?”

“That’s right.”

“Well, look. Believe it or not, urban economics models actually do suggest that Georgist taxation would be the right approach at least to finance city growth. But I would just say: I don’t think you can raise nearly enough money to run a modern welfare state by taxing land. It’s just not a big enough thing.”

The context was health care. “We’re having enough trouble trying to make sure we repeal the Bush tax cuts,” Krugman added, “and trying to shift to a completely different base of taxation is just not going to be on the table.”

When we’re talking about revenue positive tax reform, it’s useful to understand a) from what activity and b) from what individual the marginal tax dollar is generated. In a welfare maximizing system, the answer to (a) would probably be something very bad for the world like carbon and the answer to (b) would be Bill Gates. More generally, we should first tax activities that harm the world – like global warming – before we tax activities that help the world – like working. Similarly, we extracting a marginal dollar from the rich is vastly less welfare inefficient than doing so from the poor.

Most of the time, these guiding principles are in tension with each other. A tax on externality-generating activities – like a levy on gas, carbon, or natural gas – tend to disproportionately hit the poor. Likewise, a tax on the rich usually comes from what we would usually consider “good” – like returns on human or capital investment.

Land is a big exception*. Land – like almost any other store of value – is disproportionately owned by the rich. (Remember, land excludes value added property, so democratic ownership of houses across flyover country doesn’t make as big a difference as you might imagine). And while land isn’t “bad”, per se, because its ultimate supply is perfectly inelastic there is no welfare loss in its taxation (granted, there are no welfare gains either, unless it offsets an even worse tax).

(*Another notable exception might be congestion taxes in cities which fall on the people who take cabs or private cars instead of public transportation. In other words affluent tourists and the local elite).

Some people I’ve talked to don’t grasp the idea that land is inelastic. They tell me that companies will stop “improving” land for more productive use. It’s always surprising how confused people are about the idea of land. By definition land is unimproved. I don’t want to tax people who’ve built nice buildings on land or, for that matter, even deforested dense areas for efficient development (though I’d support anti-deforestation laws for entirely different reasons). That’s why property taxes are dumb.

But I want to disarm some misconceptions. When Paul Krugman says “Land is just not a big enough thing” he’s echoing a broadly held, and to some extent true, belief. In 1980, Paul Samuelson wrote:

Historically, pure land rent has become a declining fraction of GNP and NNP.

Ironically, 1980 was an important, if gradual, turning point:

These figures – land rent share of income – are, for reasons I’ll get to later, quite a bit underestimated. But for now I’m more interested in the rate of change. After secular decline during the postwar expansion, land rents have increased not just in value, but in proportion, to the incomes of the wealthiest.

The biggest reason for this is, I think, the steep rise in inequality over the same time period. Conceptually, this is a pretty sensible argument. As mass affluence increases, as it did between 1940 and 1970, demand for consumer luxuries – like fridges, air conditioners, and garments – grows quickly. But as incomes of the median workers stagnate, while those of the rich grow precipitously you see a shift in demand to zero sum goods – or land.

Think about it, beachfront property, Manhattan penthouses overlooking Central Park, and second homes in Aspen have all increased rapidly in value in the Inequality Era. That’s because as the number of people who can afford luxury products has grown substantially, so too has the dollars chasing said land.

This is a pretty informative thought experiment. Land plays a big role in all of the products in the set of goods exclusively afforded to the affluent, and especially rich. While second homes and penthouses are a great example at the primary level, think about Ski Resort owners. If you want to Ski properly – that is on the Alps or in Colorado – those fake, manmade hills won’t cut it. You need a real mountain. The former is capital, and the latter is land. And boy do rich people love their Winter Chalets on the Swiss Alps.

Once you realize that land value is the most pristine of luxury goods – fake beaches are below the rich – the potential of land taxes becomes immediately apparent.

Now, you might be wondering after all this, if only 3-4% of the richest 1%’s income is land, there’s no way a total reform can include land values only. This is correct insofar as its ambiguity. The moral and logical extension of a land value tax would include similar levies on minerals, Internet domain names from common language words, and imputed rents from “middle America”. More importantly, there’s reason to believe this figure is understated, as discussed here. The last paragraph here is conspiratorial nonsense, but Fred Foldavary gives some pretty good reasons to believe that land rents are underestimated.

Part of the problem is because the United States pursued a program of broad home ownership – along with the fact that many affluent people own only one, expensive home without renting a second one out – so-called “imputed rents” become an important part of the picture. To calculate GDP, the government uses all kinds of tricks to estimate what you would have paid to live in your house had you not owned it. Even an average of $700 a month for everyone taxed at 50% yields a very significant sum. (Especially noting that the rich are easily paying the equivalent of $5,000 a month).

Granted, going back to the tradeoff between objectives of an optimal tax system, this would also “hit” many middle-class Americans.

There’s another critical point about taxing minerals. Many think about this from the point of profit from production without considering the consumer surplus from cheap consumption. That is, because most of us – especially the rich – would (if we had to) pay way, way, way more for a gallon of gas than we do, we’re rentiers each time we pay at the pump less than we would have. Because otherwise it would have been the company’s profit which is clearly rent.

Now, it’s important to note that a disproportionate amount of fossil fuel consumption should be attributed to the rich (just look at how much they fly, and in fancy business class configurations too!) That means their rent extraction from cheap fuel is orders of magnitude worse than the average American’s.

Note this argument has nothing to do with the environmentally-efficient price of carbon: we only note that minerals are a scarce, primary resource whose rents should be treated as land, and correct for the fact that most people would pay more for the average unit than we do. This is a very non-trivial point. Once you stipulate that not only the taxes, but consumer surplus, from minerals can be taxed under Ricardian principles, there is a gold mine of untapped tax revenue. Just look at the sales of America’s oil and gas sector. Along with land, and maybe a small levy on income earned above $1M we can finance a big government (25% G/GDP) with sensible tax policies.

Here we tease an important tension. A minerals tax (in reality what should be a carbon tax, but I’ll refrain from using that language here to divorce this conversation from environmental concerns) would disproportionately hurt the poor, as it is regressive, even if the rich disproportionately abuse the cheap fuel. This is a classic case where p(a|b) is very different from p(b|a). The best way to deal with this is to still heavily tax minerals – coal, oil, natural gas, etc. – but to provide a very progressive government spending system.

I want to summarize the most important part of this post as treating consumption of minerals as crucial a component of rents as profiting from the sale thereof. This adds another inefficiency beyond the environmental cost to even just innocently buying a gallon of gas. If we all used gas equally this wouldn’t be a problem, but we don’t, so our collective benefit should be socialized.

This is a particularly shocking problem if you think about how much the rich would actually pay for a gallon of gas (or unit of coal and natural gas burned if you’re of the Elon Musk class). For someone earning $500,000 a year or more, $20 a gallon would hardly seem like too high a reservation price. (After all, people in Europe earning well below that figure pay over half that). And what of air transport? This can’t be replaced with efficient, clean travel anytime soon.

The conversation on rents from land and minerals in this time of inequality has to begin. We might not be able to achieve all of our progressive goals with only a land value tax, but once we implement taxes on that principle the revenue is not trivial. Paul Krugman is unfortunately correct that this has all but disappeared from the Neoclassical, mainstream graduate schools. But I would expect the average consumer microeconomist to understand the rent from simple consumption better than anyone else. 

People like Paul Krugman can make this debate real in a matter of minutes. There is nothing utopian, idealistic, or useless about doing what Hal Varian’s Intermediate Microeconomics would tell you to do.

P.S. The name for this post comes, of course, from David Ricardo who first (or at least most prominently) advanced this argument:

It was from this difference in costs [between productive and unproductive land] that rent springs. For if the demand is high enough to warrant tilling the soil on the less productive farm, it will certainly be profitable to raise grain on the more productive farm. The greater the difference, the greater the rent. 

P.P.S. I plan to write some more on the evolution of economic thought regarding land. Some of the crispest writing on land rents comes from the classical greats like Ricardo or Henry George years after that. In any case, the modern arguments for land taxes usually come from the extremely utopian libertarian wing which makes a great argument but does alienate support from the “mainstream”. A lot of what Ricardo wrote doesn’t apply today, and mechanism of rent-seeking certainly manifests itself in subtler ways than before. But it is time to bring land and mineral taxes back into the heart of mainstream progressive discussion: something even the wonkiest seem hesitant to do.