Chapter XV: Taxes, Economic Rent, and Externalities

What Should We Tax?

We began our examination of government by looking first at proposals to reform the tax system and noting their deficiencies. We then looked at both the purpose and cost of government and noted that government has exceeded its legitimate purposes and hence its reasonable costs. We can now return to the question of tax reform, and determine how this should be done, because at the heart of governmental reform is tax reform. It is evident by now that the “starve the beast” strategy was a failure; under this strange diet, government “bulked-up” rather than “slimming-down.” Only by identifying the proper sources of public revenue, and insisting that government stay within these limits, can we hope to achieve any real reform. So the central question is, “What should we tax?”

There is a bromide about taxes that goes, “If you want less of something, tax it.” Currently, the burden of taxation falls on capital and labor. Now, I can't think of any reason why we would want less less labor or less capital; therefore, the fairest and best tax on labor and capital is a flat-tax of zero percent, with some notable exceptions, discussed below. But if we eliminate taxes on labor and capital, is there anything left? Is there anything in the economic universe that we want less of? I believe there is. In fact there are two things that can be taxed, one with no impact on economic development, and the other with the deliberate goal of limiting adverse impacts. The first thing is economic rent and the second is taxes on externalities.

Ground Rent

I repeat here our discussion of economic rent from Chapter X: Economic rent is an amount paid to a factor of production that is more than necessary to keep that factor in production in its current use. It is the very essence of economic inefficiency. For example, the price of steel must be enough to pay for the raw materials in the steel and to compensate the labor and capital that went into making it. If, however, the price rises very much above this amount, then steel claims an economic rent. This rent acts like a tax on all users of the steel, a tax that really doesn't buy anything, but only transfers money from one group (the consumers) to another (the owners). In the case of elastic, reproducible commodities (like steel), this is only a short-term problem, since (in competitive markets) the higher prices attract more labor and capital, the supply is increased, the prices fall, and the economic rent disappears. In the short-term, and for normal commodities, economic rent serves a purpose.

But this does not happen in the case of land; there, the rent is chronic and distorts the returns to both capital and labor. Recall the discussion of the law of ground rents from Chapter IX. Ground rent has the first claim on all incomes, and returns to labor and capital (“the wage line”) can only be paid after ground rent is satisfied. Moreover, this ground rent represents unearned income. Property increases in value because of the growth of population, improvements in technology, or off-site improvements. None of these things are attributable to the land owner; he merely reaps where he did not sow. All ground rent is economic rent. Land costs nothing to keep it in production. Capital and labor are consumed in the process of production and must be replaced; the land endures.

Consider a case where a landowner leases out a piece of property to an entrepreneur to build a factory. The factory lasts, say, thirty years, and at the end of the time it is “used up.” It is torn down and hauled away. But the land remains and is ready for the next use. All this time, the landlord has been receiving an income, and all the while the property has been increasing in value (assuming an increase in population and advances in technology). Yet the landlord did nothing to earn this income; it is strictly a reward for owning the property, not for using it. The income is due to the community, and by rights should go to the community.

Note that we are speaking of taxing only the ground rent; the improvements would not be taxed at all. The improvements to the property represent capital and labor, and their work should not be taxed. Only the ground rent, the portion provided by the community, would be taken, and taken at something close to 100% of its value. This is not a new idea. It was the form of taxation favored by economists from Adam Smith to Milton Friedman. It was most famously popularized by Henry George, a name that is forgotten today, although he was the most well-known and popular of the economists of the late 19^th and early 20^th centuries. Some measure of his popularity can be gathered from the fact that at his death, 100,000 people filed past his coffin, and thousands of others waited outside and could not get in to pay their last respects. Can you imagine the general public lining up to for the funeral of any other economist?

George's theory is often called a “single-tax” theory, because it reduces all taxes to ground rent alone. However, this is a misnomer, since it should be called a “no-tax” theory. A tax is a cost added to a price or subtracted from an income. A sales tax is added to the price, an income tax deducted from the income. And these taxes tend to get passed along to the final consumer. But the Georgist “tax” simply appropriates the income of the rentier, the person who lives off other people's work. Nor can this “tax” be passed along. Ground rent already tends to absorb all values over the margin of production; the price cannot be increased beyond this.

The major question is whether such taxes are just, whether the major burden of taxation should fall entirely on the rentier. Two points are important here: One is that the value of ground rent is due to the community, not the owner (Chapter IX). It is but justice that the community be funded from its own natural revenues. The second point is that ground rent always represents wealth without work, the primary source of both economic inefficiency and economic injustice. Wherever one person gets wealth without work, another must provide work without wealth. Clearly this is unjust, but it is also inefficient. The maldistribution of incomes affects such technical measures as the velocity of money and the incentives to invest, and thereby destabilizes the economy. But further, it leaves the community without a source of revenue for public purposes; the community therefore has no choice but to go after the returns to labor and capital, which negatively impacts both. Taking the ground rents impacts neither—any further than rent does, anyway. Therefore, we can assert that ground rent is the natural income of a community. Rent derives its power strictly from a legal claim to property; that is to say, it is a creation of government power, a power that recognizes no limits to property. But property, like any other natural thing, has natural limits. And the natural limit to property is that one should profit from its use and not from mere ownership.

Taking ground rent would have profound macroeconomic consequences. For one thing, land speculation would be unprofitable. The only way to make money off of land would be to use it, to employ it in providing a useful good or service to one's neighbors. The whole problem with the speculative rent line and the resulting land bubbles and subsequent contractions would disappear. The economy would be far more stable. For another thing, wages and investment would get their full return; both are now burdened by both rents and taxes. Without taxes on either, the work and investment climate would be very much improved.

But is it Enough?

Although many economists generally concede the superiority of ground rents, they also doubt that it is adequate, especially when the total government expenditures come to $5 trillion. In this critique, they are absolutely correct. It is unlikely that ground rents could support a government establishment that takes one-third of GDP, an amount that is growing, especially during this current crisis. But that is not so much a critique of the land tax as one of its greatest advantages. Under a land tax, the public revenues would be fixed and known. Government at all levels would be confined within the limits of their funding. But how much would that funding be, and is it adequate to a reasonable level of government?

Empirical studies are hard to come by, since local taxing authorities are not overly concerned with separating the price of the land from the price of the improvements. The best studies suggest that ground rent revenue would come to about 20% of GDP, or about 60% of funding at all levels of government.¹ This would certainly leave a big hole in the current level of government, but this might not be as big a problem as it appears at first glance. It would force government to consider what should be funded from general revenues, and what should come from user fees. We have already discussed how the highway system is the obvious example of an expense that can be moved from general revenues to tolls. But there are many items in the budget that are in fact services to particular clientèles. For example, the Food and Drug Administration is a service to the pharmaceutical firms, among others, and its entire budget should come from user fees. By cutting the bloated defense budget, going to debt-free money, eliminating useless departments such as education, charging public works to the properties that benefit from them, and such like measures, the federal budget could easily be cut by 40% without compromising any current services.

I suspect that the same rules would apply to state and local governments. The lion's share of these budgets are consumed by an ever-more-expensive education system. However, while it is certainly a duty of government to ensure that every child has the same opportunities to get an education, there is no reason for the state to actually run any schools, a task which they do not do well. A system of vouchers to parents would likely bring both great diversity and great economies to the educational system, while allowing the public to recoup their investment by selling the schools and putting the land back on the land-tax rolls. Support for education should also include some modest support for home-schooling.

Political Effects

Political power tends to flow to the greatest funding source. When the Federal Government gained the power to tax incomes, power naturally flowed upward, so that today senators and presidents routinely handle matters that are best left to the town council or the statehouse. A land tax, however, is most efficiently collected at the local level. The apparatus for doing so is already in place, since localities collect property taxes, though under widely varying rules and rates. The rules and methods would have to be standardized across the nation. But a land tax would entirely change the nature of government in the United States. With taxes collected at the local level, and divided in a fixed proportion among local, state, and federal authorities, we can expect that power will begin to flow back to the states and cities. And with a fixed budget, it will be easier to confine the federal government within its constitutional limits.

I suspect that the two great debates in a land-tax system will be how to split the revenues and which programs should be funded or subsidized from general revenues and which should be funded by user fees. As matters currently stand, states and cities have an incentive to “kick problems upstairs” to the federal government, where the money is. Relying on the federal budget allows local entities to claim a bigger share of the income taxes their citizens pay, and to isolate the local tax base from these responsibilities. But a land tax reverses these incentives; since the tax base is the same for all levels of government, only the division of the revenues is at issue. Local entities therefore have an incentive to accept greater responsibility and hence claim a greater share of the revenue.

Further, they have an iron-clad argument when dealing with the federal government; they merely need to ask about any particular program, “Where in the Constitution is this authorized?” Of course, they have that argument today, but they are not inclined to use it because the funding argument will always trump the Constitutional one. Under a land tax, both arguments will work in favor of the local entities. The land tax will therefore advance the distribution of power which is an essential part of distributism. It will also encourage leaders at all levels of government to offload as many programs as possible from general revenues to fee-based services.

The Land Tax and Distributism

In advocating the land tax, I am not advocating something without historical precedent or current practice. In fact, the majority of tax systems before the modern age were based on land. The English feudal system was essentially a land-tax system. And in the modern world, highly successful states like Singapore, British Hong Kong, and Taiwan are “Georgist” land-tax states. However, these states also indicate the problem with the land tax. In theory, the value of land should be easy for the authorities to calculate, since there is always an active market in land. And this is true, so long as there are no tax implications in separating the price of land and the value of the improvements. Two problems arise: One is that since improvements are not taxed, there is an incentive to attribute as much value as possible to the improvements and as little as possible to the land. The second is that when land ownership or control is concentrated, the landowners exercise considerable influence in setting the rules. Thus, a “pure” land-tax system has been difficult to establish or maintain over time. It tends to degenerate into a mere property tax which is insufficient to fund the state and becomes supplemented by income and other taxes (although usually at a much lower rate than in non-Georgist states). Large landowners like to see other taxes, because these are easier to avoid or to pass on to the final consumer.

The land tax works best where ownership is well divided and property not concentrated into large estates or tracts; in other words, in a distributist state. With land well distributed, political power is also well distributed, and the incentives to “off-load” the taxes from land to labor are decreased. On the other hand, a distributist state needs the land tax to prevent property from re-aggregating; without a land tax, the distributist state tends to degenerate into a capitalist state, and no one is better off. Therefore, a Georgist polity needs distributism for its implementation; distributism needs Georgism to maintain itself.

Other Forms of Economic Rent

Land rent is not the only form of economic rent, even if it is the most obvious and important one. Other rents arise from monopoly or oligopoly control of economic resources, from patents, from control of scarce commodities, and from occupying positions of power with large institutions, mainly the corporation. This rent manifests itself in various ways, but the most obvious way is suspiciously high returns to capital. To deal with these other forms of rent, I suggest that the corporate income tax be maintained, but only assessed when the return to capital gets to be outsized. I suggest that we adopt some figure as a “normal” return to capital, say 8%, and start a modest tax when double that return is reached (16%), a high tax when it is tripled (24%), and a punitive tax when it is quadrupled (32%).

This would not impact the willingness to invest. While in general high returns attract investment, such returns, like every other economic quantity, have a “marginal utility.” That is, at some point, higher returns do not attract additional capital, and at a higher rate, the returns actually act as a perverse incentive to discourage further investment. This is especially true in monopolies or oligopolies. When returns are so high, why invest to increase the supply and thereby lower the returns?

In the same vein, high-level executives often collect an economic rent in the form of perversely high salaries and bonuses. These salaries seem to be paid whether or not the enterprise is successful, and indeed some of the highest bonuses are paid for failure, such as when a CEO with a “golden parachute” is fired. These bonuses come out of the rewards that rightfully belong to the workers or the investors. One or two generations ago, a CEO would typically make 20 to 40 times what the line worker made; now CEO salaries run 300 to 500 times that of the line worker. The simplest solution is to require corporations to pay a tax penalty for such salaries. When a salary reaches some multiple of the line worker's salary, say 40 times, the company would pay at least a modest tax, a tax that at some point, say 200 times the average, becomes punitive, in the 75-90% range. Note that this tax would be on the company, not the executive. It would entirely change the nature of the negotiation with that executive, would be certain, and would be easier to collect.

Externalities

Aside from wealth without work (economic rent), the other great economic evil is forcing some portion of the costs of a transaction on some third persons who are not a party to the transaction. Firms, and especially large corporations, do their best to externalize as many of their costs as possible. The obvious example of an externality is pollution, by which a company will treat the common air, streams, and ground as a free sewer. This sewer will have no cost to the company, but surrounding communities will pay the cost in declining health, increased medical expenses, and shortened lifespans.

Externalities take many forms. One common form is subsidized infrastructures. The “free” transportation systems, for example, are actually subsidies to businesses that depend on wide distribution and supply networks. These subsidies work to the disadvantage of local businesses and suppliers, because they unfairly lower the transportation costs of national and international competitors. “Big-box” stores like Wal-Mart could likely not survive if their transportation costs were not subsidized. This is especially true since the greatest amount of damage to roadbeds is done by large trucks. If there were weight-based tolls for using the roads, it is likely that the Wal-Mart model would simply be uncompetitive with local and regional producers and retailers.

Externalities distort the price system and give companies that can externalize their costs a competitive advantage over those who cannot. As it works out in the real world, it is large, international companies that can more easily take advantage of externalized costs, leaving small and local competitors at a disadvantage.

Aside from going to fee-based services, like tolls, government should use its taxing power to force companies to internalize all of their costs. The current “big idea” for controlling pollution is “cap-and-trade” systems. But such systems convert pollution into a property right, and then give the right to the wrong people, to the polluters rather than those harmed by the pollution. Clearly, if you want more of a thing, turn it into a “right,” especially a marketable right. You may take it for granted that the producers can produce more forms of pollution, and therefore more property rights, faster than you can print the new deeds. The best method is a scale of taxes on pollution that increase over time so as to “encourage” a firm to internalize all of its costs.

In general, government should be vigilant to detect and eliminate externalities. No price system can function properly if firms are freely allowed to externalize their costs either to government budgets or to the public “commons.”

But Should We Cut the Budget?

We have assumed throughout this discussion that cutting government expenditures and eliminating economic rent and externalities are good things. The reality, however, is a bit more complex. The current industrial system actually depends on large government expenditures, economic rent, and the ability to externalize costs. So while cutting the budget in the abstract would be a good thing, in reality it would destroy the current system of industrial production and global trade.

So before we take our scalpel in hand to perform surgery on the budget, we need to understand what we are doing and where we are going. We need to couple fiscal reform with a reform of the industrial system itself. Otherwise, our surgery may be successful but the patient will die. What a new industrial system could look like, one not dependent on government largesse, is the subject of the next chapter.

1Fred Foldvary, “Intellectual Tyranny of the Status Quo,” http://www.econjournalwatch.org/pdf/FoldvaryIntellectualTyrannyApril2005.pdf.

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Gasoline: Too High and Too Low

We often hear that the internet has created a brave new world of globalization. But the truth is that the internet had very little to do with it. The net has allowed certain jobs to be outsourced, like help lines moved from your home town to India, where nobody can give you any help. But globalization preceded the internet, and depends on two other things. Namely, the shipping container and cheap oil. Prior to the shipping container, goods had to be manhandled onto a truck at the factory, manhandled off the truck and onto the ship at the port, and off the ship and onto a truck at the next port. All this manhandling made shipping costs too high for low-valued goods, such as lead-painted toys from China. But now the toys, lead and all, can simply be loaded into a container in a remote area of China and never touched again until they reach a Walmart warehouse in a remote area of the United States. This means that the lowest paid workers in the most remote parts of the world can compete with the working man down the street. And all of this is made possible by cheap energy.

The shipping container is here to stay, but not so cheap energy. That long ride from Sichuan to Beijing, that long voyage from Beijing to Los Angeles, that long trip from LA to Arkansas is becoming prohibitively expensive. The net effect should be to make American-made goods cheaper relative to foreign goods. And that's good for America. So, is the run-up in oil prices good or bad for America overall? The truth about any price is that it should not be high or low, but that it should be right. What is the right price for any commodity? It is the price that adequately compensates all the labor used up in its production, (including the “stored-up” labor known as “capital”), and that it account for all the “externalities” of the commodity. Now, the production costs of oil are very low. It costs the Arabs about $9 to raise a barrel of oil to the surface. Even adding in the handling and shipping costs, one can still make a nice profit at $120. So it would seem that the price is too high. On the other hand, the externalities of oil are very high. Obviously, there are the costs of pollution, but there are also other external costs: the cost of armies stationed abroad and wars to protect remote supply lines; the cost of highways, the least efficient form of transportation. Cheap energy has made possible the automobile, which has changed the shape of cities, or rather made cities somewhat shapeless and sprawling. This has imposed tremendous infrastructure costs on cities, costs which they have difficulty recovering. And many more things could be added to this list of externalities.

The answer is, then, that from the standpoint of economic rent, the price is too high, and from the standpoint of economic externalities, the price is too low. So what policies should be followed in a “too high/too low” situation? One answer is given by those who want to follow the European model, by which gas is already taxed to the point of being twice the cost it is here in America. This model has some success, in that the Europeans drive smaller cars and drive them less because they live closer to work and shopping. Even naïve libertarians like Charles Krauthammer have endorsed this solution. But I believe this European/Libertarian solution to be too crude and too government-oriented to be what we need now.

Hillary Clinton and John McCain are taking the opposite tack, at least in the short-run; they want to lower the taxes on gasoline. McCain's proposal really means that he wants to borrow more money to buy votes; Clinton at least wants to finance the cut with a tax on the oil companies, who can well afford it. And everybody has their own private palette of long-term solutions, some good, some dubious: more conservation, more drilling, more nukes, more carbon-taxes, more mileage standards, more ethanol, more ANWR. These solutions are indeed long-term, and will do little in the short-run. But since this is a game anyone can play, allow me to offer my own menu of solutions, solutions which address both the “too high” and the “too low” aspects of the problem.

Gas is Too High (Economic Rent)

It is beyond question that the high profit margins of the oil giants represents an economic rent, and such rents, or at least some portion of them, can always be recovered through the tax system without negatively affecting the economy. See (Taxes: Advice from Adam Smith). Some will argue that taxing the excess profits will reduce incentives. However, this argument ignores the fact that incentives, like every other economic quantity, are marginalized; that is, they are subject to the law of diminishing returns, one of the most basic of all economic laws. At some point, an additional dollar in incentives will not lead to an additional dollar invested in drilling, and the next dollar in incentives will actually lead to fewer dollars invested. Excess profits, when they truly are excess, when they truly constitute an economic rent, can safely be taxed. Further, it is far more efficient to collect the gas tax at the producer level than at the retail level. Hence, we can transfer the tax at the gas pump to an excess profits tax, and get the same money (or more) at a lower collection cost, and less aggravation to nearly everybody, except for a few oil company executives.

Some will argue that this will only increase the incentives to drive more and waste more, and they would be right, if it is not coupled with measures to address the externalities.

Gas is too Low (Externalities)

The most important thing is to end the system of subsidies known as the “freeways.” Roads should be funded by tolls, as I have argued previously (see Free Markets, Free-ways, and Falling Bridges.) This places the cost of remote living on those who wish to live remotely. More power to them, but don't ask the rest of us for a subsidy. The toll makes the gas tax unnecessary, to the extent that the tax is used to fund roads.

Mileage Standards are needed, but not as a set of bureaucratic diktats enforced by ever-growing bureaucracies. They can more easily be enforced by a system of consumption taxes and subsidies paid at the time of the purchase of a car. For example, suppose that the government sets a target of 35 MPG. A car that is judged to meet the standard would neither be taxed nor subsidized. But one that got only 25 MPG would pay a steep luxury tax, and one that got 40MPG would get a rebate. Those who insist on buying the biggest Hummer they can get will be taxed to support the more frugal driver. Think of it as a cap-and-trade system of carbon taxes for the common man. As it is, the cap-and-trade advocates only like it when it can be used by corporations. But if it is good enough for Dow Chemical, it is good enough for all of us.

The same principle can be used for anything that consumes large amounts of energy: furnaces, hot water heaters, appliances of all sorts, etc. Suddenly, there will be real economic incentives to buy the most efficient products, and disincentives to waste energy. And the same thing can be done for home energy costs: end all the taxes on energy bills, but place high luxury taxes on high users. Those who want to cool their homes to 60 degrees in the summer and warm it to 80 in the winter will pay a high premium to do so, while those who combine modest heating with warm clothing will see a reduction in their bills. Note that all of these taxes are avoidable to the extent that high energy usage is avoidable. Those who are responsible are rewarded, and rewarded without extensive bureaucracies. Those who want to live large will pay much, and more power to them. But in both cases, people are free to make a choice, even if we use public means to influence the choice.

I believe these principles will completely change the energy markets as we know them, and make the whole system more economically efficient. Nor do they require great social changes and high investments for them to be immediately effective. However, they will encourage great social changes in a relatively short period of time, changes that will be of great social and economic import.

The sages at Lehman's are predicting $200/barrel oil, and T. Boone Pickens has picked $150 as his target. Now, I am in no position to quarrel with these worthies, but I suspect that oil will actually drop 10% or 20% before it rises. But even if it drops, it will still be expensive, and that is not something that is likely to change in the current state of things. High oil prices can actually be good for the economy; they can actually increase our domestic production, while making alternatives cost-effective. And they can fund all sorts of new industries. It is not the price of oil that is the problem, but how we respond to it, or fail to respond.

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The Romance of Cost Accounting

When we think of persons associated with the phrase “social justice,” any number of images might spring to mind. Some might think of Dorothy Day and the Catholic Workers Movement. Others might conjure up an image of revolutionaries seeking to overturn the capitalist system, or of reformers trying to change it. And some might simply regard the term as a fixation of fuzzy-headed liberals, with little connection to the real world of business and economics. But one person we rarely think of is precisely the person whose role might just be the most critical, and that is the cost accountant.

Now, we rarely associate accountants with either romance or revolution, much less with fuzzy-headed liberalism. Nevertheless, if we take the notion of justice seriously, then surely it must involve the notion that costs are fairly allocated to the persons who cause them. That is to say, one person is not making an involuntary contribution to the success of another, that one person's poverty is not subsidizing another person's wealth. We assume that when we purchase something, the price covers all of the costs; we would be surprised to learn that some portion of the cost was not included in the price, that someone else was helping us to pay for what we consume. And yet, this is something that happens all the time; the price we pay for products does not cover the cost of producing and disposing of them. This is a phenomenon known to economists as externalized costs, that is, costs of a transaction that are not borne by the parties to the transaction, but are passed off to someone else, someone not involved in the transaction and who derives no benefit from it. The most obvious examples of externalities are pollution and subsidies. When a company can get the government to bear some portion of its expenses, its costs are passed on to the general public, while the profits are kept by the company; its expenses are socialized, its profits remain private. When a production process devastates the environment, then real costs are incurred—in the form of higher health care and ruined land—but not included in the price.

To the extent that prices do not cover costs, then basic justice is denied. When we rely on exploitation, subsidy, and pollution to provide us with all the goods that we purchase, then basic justice is denied. We may think that we are getting a bargain, when what is really happening is that someone else is getting shafted. Now, it is the job of the cost accountant to pore over columns of figures in ways that would not be interesting to you or me. Indeed, the accountant performs a function which would be tedious to the reformer, but without which reform has no real function. To the extent that justice can be reduced to a proper accounting of costs, than the cost accountant is the real revolutionary, the genuine reformer. And one way to judge the justness of an economic system is to measure the amount and extent of the externalities.

But the job explaining externalities is a difficult one, and the task of spotting them is a tedious one. At least it always has been for me. But comes now Annie Leonard who has made a light-hearted animated film, The Story of Stuff, that explains the topic and examines the extent of the problem. And it turns out that the economy is rife with externalities, with costs that are sifted freely from one group to another, creating an economy of winners and losers that has nothing with “market forces” but rather with the application of force to the market. Here is the trailer:

The film is 20 minutes long, and can be purchased for $10 or downloaded for free. I highly recommend this movie for anyone who wants to understand the real economy, and not the fantasy economy described in so much popular literature and political rhetoric.

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