Economic rent is not rent. Most people think of rent as a periodic payment for the use of real estate. However, the term economic rent is used to define a fundamental aspect of any economy. Economic rent is the revenue that can be earned from the land or other natural resource for which there is a fixed supply — as economists like to say, the supply is perfectly inelastic. Because the supply is perfectly inelastic, the amount of its supply does not depend on any income that the resource can produce. Increased demand does not increase the supply because it is a natural product that was always available. Hence, it is a free gift to society.
When people first came to populate a land, the land was there for the taking — no one produced the land because of their efforts. Hence, whatever revenue, or rent, can be earned from the land is unearned by the landowner. For instance, consider 2 farmers, who each have one acre of land. Each practice farming in exactly the same way, with the same real capital, but the first farmer can produce 100 bushels of wheat from that acre, while the 2nd farmer can only produce 40 bushels of wheat. The difference in output between the 2 farmers is due solely to the fertility of the soil. If the competitive price for wheat is $10 per bushel, then the first farmer earns $1000 while the 2nd farmer earns only $400. The difference, $600, is attributed solely to the differences in the quality of the land for producing wheat. Note that the first farmer did absolutely nothing to earn the extra $600 — it is a free gift of nature. Hence, the $600 is considered the economic rent that the first farmer earns over and above what the 2nd farmer earned. Now the 2nd farmer also earned some economic rent, since no wheat can be grown without land, but that economic rent cannot be determined without another reference, because even though the 2nd farmer earned $400, some of those earnings are the result of his labor and his capital.
To put economic rent into its proper context, the production of any product or service depends on the 3 major factors of production: land, capital, and labor. When you buy a house, you are mostly paying for the capital and labor of constructing the house and also for its location — only a small portion of the price is for the land itself. Although you shop for a house that you will enjoy, the price that you are willing to pay will also depend on what price you think you can sell it for later on. When a builder buys an empty lot, the amount that he is willing to pay will depend on what type of house that he can build and how much he can sell it for.
Determining Economic Rent
Among the factors of production, land is fundamentally different from labor and capital, because the supply of labor and capital depends on its price in the marketplace while the supply of land does not. Land rent has no incentive function because the supply of land is not dependent on the rent paid. Land rent is considered a surplus payment, because even if no rent was paid, land would still be available.
Although economic rent cannot be determined absolutely, a good approximation would be the price paid for undeveloped land, because this price is what the buyer and seller believe to be the worth of the land itself as a factor of production in its projected use. However, if the land is already developed, then it will be difficult to determine economic rent since the price will also include the development, and any buyer would only be concerned about how much revenue could be earned from the developed land. How much of the price is attributed to economic rent is immaterial to the buyer.
What is true of land, is true of all natural resources: minerals, oil, natural gas, coal, all bodies of water, the electromagnetic spectrum, and even outer space, because even space itself is a natural resource. Indeed, most people and businesses use land for the space that it provides.
Economic Rent = Price of Resource in its Native State
In this sense, economic rent is much like economic profit, which is the profit over and above what is necessary to compensate the entrepreneur for her opportunity costs.
Allocation of Natural Resources
So how are these resources allocated? Because these natural resources are freely available, governments often sell these resources in auctions, so that they are sold to the highest bidder, who presumably can make the most productive use of the resource. At the same time, the government can use the revenue from the economic rent for the benefit of all instead of allowing a few individuals to profit from a free resource. Allowing the ownership of natural resources also prevents the tragedy of the commons, where people deplete a resource without regard to preserving the resource or to find its most productive use.
The highest bidder will be the one who projects that his use of the natural resource will produce a product most desired by society, so that he will be able to earn the maximum revenue obtainable from that resource. Because the bidder projects higher revenue for his use of the resource, he is willing to pay a higher price. So even though the supply of land is perfectly inelastic, the demand for land depends on its productivity. Although economic rent is not an opportunity cost for the economy, because the land is there regardless of what the economy does with it, it is to the buyer, since the buyer must choose among the many possible investments that can be made. This is why if someone buys an acre of land in Manhattan, they are going to build a skyscraper — not a house — because they can earn so much more money from renting out a skyscraper then they could from renting out a house.
Henry George and the Land Tax
The physiocrats were a group of French thinkers in the 18th century who recognized that land was a major source of wealth for any economy. Indeed, the physiocrats believed that land is the source of all wealth, hence, it should be the only thing taxed. However, their philosophy was doomed because of their emphasis on agriculture and because many of their ideas were wrong, such as that capital and labor do not contribute to wealth, which is obviously false.
Nonetheless, the idea of applying a single tax on land appealed to one of its most famous proponents, Henry George, which he expounded in his book Progress and Poverty (1879). Since land could be taxed without diminishing the supply, George argued that land should be taxed because landowners did nothing to create the land — they simply received it by chance, inheritance, or payment. Furthermore, unlike the effect of most other taxes, there is no reallocation of resources when land is taxed, no economic distortion.
Note that George's land tax is a tax on the land itself, not on any buildings or other structures that would ordinarily be considered part of the real estate. Hence, the land tax proposed by George is different from real estate taxes, which are assessed on the value of the real estate, including the buildings on the land. Real estate taxes will lower the development of property, which will result in the same deadweight losses that usually result when something is taxed.
George considered a land tax to be not only fair but also efficient. It would be very difficult to evade a land tax, so the administration and enforcement of the tax would be easier.
A land tax does not distort economic decisions — it simply lowers the amount of money that landowners receive for their rent by the amount of the tax. No tax burden falls on the buyers of the land, since they are only willing to pay so much for the land regardless of whether the money goes to the landowners or to the taxing authorities.
There are several major criticisms of Henry George's single land tax. The primary problem is that it is difficult to determine how much of the revenue earned by the land can be attributed to the land itself and not to property development, or the labor and capital needed to produce the product or service. Another problem is that the tax burden would fall on current landowners rather than to previous or future landowners. Moreover, a land tax could never support the huge governments that exist today, especially since tax revenue depends on the velocity of money, where each transaction is taxed. Since there are many more transactions in the marketplace for goods and services than for land, more tax revenue can be collected by taxing everything rather than just land.