The worst enemy in economics: privatized economic rent

During my PhD-studies in moral philosophy I was wondering: what is my worst enemy in ethics? I consider discrimination, or more generally unwanted arbitrariness as the biggest problem in ethics. Now that I’m studying for a master in economic policy, the question becomes: what is my worst enemy in economics? As I was most affiliated with radical left-wing, anarchist, socialist, communist and deep ecologist traditions, in the past my answer could have been something like ‘business profits’, ‘high executive salaries’, ‘big corporations’, ‘private property’, ‘privatization of public companies’, ‘positive interest rates’ or simply ‘capitalism’. However, when I learned more how to think like an economist, I became much more skeptical to these radical left wing economic ideologies. The supposed problems contain some element of truth, because they can sometimes involve injustice (e.g. unjustified inequality) and inefficiency (e.g. environmental degradation). But I think we can be more specific in targeting the most crucial problem in economics.

So, after a long reflection, what do I consider at this moment of my economics education the biggest problem in economics, the worst enemy? In general I would say ‘unjust inefficiencies’, which is comparable to the general problem of unwanted arbitrariness in ethics. I guess every economist is against situations or economic measures that are both unjust and inefficient at the same time. But to be more specific, I would say the worst enemy in economics is the privatization of economic rent or synonymously; privatized excessive scarcity benefits.

What is economic rent?

Very simplified, we can say that profitting from economic rent (i.e. rent seeking) means taking wealth instead of producing wealth.

Economic rent has several slightly different definitions in the literature. I would use ‘excessive scarcity benefits’ as a synonym. This notion includes other concepts, such as resource rent, scarcity value, monopoly profit, abnormal profit, economic profit and Georgist unearned income. It can be contrasted with normal profit, producer surplus, passive income, interests, Marxist surplus value and Marxist surplus product. Sometimes there is overlap, e.g. between producer surplus and economic rent, but I think the notion of economic rent more accurately describes what is wrong in our current economic systems. The set of situations that involve economic rent best fits the set of situations in our economic system that are both unjust and inefficient.

I will define economic rent or excessive scarcity benefits as: the received benefit to an owner of a scarce factor of production in excess of the minimum payment required to induce the owner to bring the factor into production. To better understand this definition, it helps to clarify the crucial terms with examples and synonyms.

‘Received benefit’ means or includes ‘payment’, ‘income’, ‘imputed value’, ‘utility’ and ‘service of an input’.

‘Owner’ means or includes ‘supplier of productive input’, ‘owner of a property’, ‘holder of a license’ and ‘occupier of a scarce position’.

‘Scarce’ means or includes ‘rivalrous’ (the ownership, use or consumption by one owner prevents simultaneous ownership by other owners, or the use by one party reduces the ability of another party to use it) and ‘having non-zero marginal production costs’ (the cost of supplying one extra unit of the factor of production is higher than zero).

‘Factor of production’ means or includes ‘productive input’, ‘property’ and ‘resource’.

‘Minimum payment required’ means or includes ‘the minimum amount necessary to keep the factor in its current occupation’, ‘the minimum supply price’, ‘the minimum amount necessary to attain the services of the production factor’, ‘the normal return necessary to keep the production factor in its current use’, ‘the costs needed to bring that factor into production’, ‘the opportunity costs’ (the value of the most valuable choice out of those that were not taken), ‘the input’s reservation value’ (the income that the owner of an input could get by deploying the input in its best alternative use, the next-most-lucrative employment open to the factor) and ‘the minimum amount that someone has to pay to hire the input’.

‘Induce’ means or includes ‘incentivise’.

‘Bringing the factor into production’ means or includes ‘selling the property’, ‘offering the factor for use’ and ‘letting the factor produce something valuable’.

In a market with supply and demand, we have a pure economic rent when a part of the supply or the demand curve (the price level in function of the quantities supplied or demanded) is vertical. That means there is a quantity of the production factor at which its supply or demand is completely inelastic: increasing or decreasing the price level does not change the supplied or demanded quantity. This is the case when there are no substitutes for the production factor. It means that at this inelastic quantity, the suppliers (producers) or buyers (consumers) are price setters instead of price takers. The suppliers or buyers have a market power, like in a monopoly (a market with a single supplier) or a monopsony (a market with a single buyer).

In the figure below, the pure economic rent is the grey area between the maximum and minimum price levels P_MAX and P_MIN. So the economic rent is the difference between the maximum amount a buyer is willing to pay to have the full factor of production in its occupation and the minimum amount that has to be paid to the supplier to have the full factor of production in its occupation.

Land value is an example of economic rent: as it is impossible to create or destroy land, the supply of land is fixed. For a quantity of land less than the maximum available land area, the production costs are zero and hence the supply curve is a horizontal line at zero. But at the maximum available land, the production cost becomes infinite, so the supply curve becomes a vertical line. Land is a price inelastic resource.

Examples of economic rent

There are many examples of economic rent, most of them are in two major categories: resource rent and monopoly rent.

Resource rent is the value of owning a property that has zero investment costs (zero marginal costs for the production of one extra unit) and was not produced by the owner. Think about a piece of land, natural resources, the  electromagnetic spectrum (for data transmission) or inherited property. It also includes the value of pollution rights, such as greenhouse gas emissions, because those emissions involve an appropriation of a finite resource such as the limited CO2-absorption capacity of the Earth.

Economic profit is the value as the result of market restrictions (markets with entry and exit barriers), and includes monopoly rent (the market power of a monopoly). Think about superstars (e.g. limited positions in music charts and theaters), professional athletes (e.g. limited positions in major football leagues), guilds (e.g. professions with a limited number of licenses), labor markets of countries with migration restrictions, seigniorage (e.g. commercial banks that earn interests on money they created by loans through fractional reserve banking).

Why is privatization of economic rent bad?

In economics, there is often a trade-off between justice (equity) and efficiency. For example, a progressive tax can give incentives for people to become less productive, decreasing the overall wealth or welfare in the economy. Justice is increased (unjust inequality decreased), at the cost of less efficiency and a loss of welfare. It is like using a leaky bucket to redistribute water.

But sometimes there is no trade-off. Sometimes an economic situation can be both unjust and inefficient, and solving that problem can increase both justice and efficiency. The privatization of economic rent is such a problem: it is unjust and inefficient. The privatization means that the benefits of economic rent go to some individuals instead of the whole community.

The privatized economic rent is unjust, because it involves unearned income for some owners of a scarce factor of production. Landowners earning a lot of money by renting their land to other people, can become rich without effort: they did not put any effort in producing the land. A monopolist business owner in a market with a natural monopoly, can earn a lot of money (monopoly rent) although he or she did not produce the situation of a natural monopoly and definitely did not create added value by earning the monopoly rent. Talented superstars or professional athletes are not responsible for those talents, but still they profit from huge earnings due to the economic rent of limited positions. Economic rent is unearned because of the lack of effort or responsibility in producing the factor of production, and the privatization of economic rent generates high income inequalities.

Economic rent also involves inefficiency. For example monopolies generate a deadweight loss or excess burden: compared with a market of perfect competition, a monopolist does not produce the amount that maximizes overall (producer and consumer) surplus. With entry and exit barriers, potential win-win market transactions are lost. This lost productivity means lower economic welfare.

In some cases, such as pollution and emissions, the economic rent causes an overexploitation of a natural resource, such as the CO2-absorption capacity of the Earth. Too much carbon emissions, more than the climate can deal with, causes serious climate change. In other cases, such as private property of natural resources, economic rent causes underexploitation of that property. This results in an allocative inefficiency. Someone can own a piece of land, and earning economic rent could mean that the owner is not willing to sell the land to someone else who is able to use that land more efficiently or productively. If someone else values a property more than the current owner (i.e. has a higher willingness to pay to own that property), that person is not always able to buy that property from the owner, because the owner has a monopoly power. This power allows the owner to set the price, and so the owner can demand a price that is too high such that the transaction will not take place. The under- and overexploitation of factors of production are examples of inefficiencies.

Solutions

As the privatization of economic rent involves both injustice and inefficiency, its solutions could improve both justice and efficiency. There are two kinds of solutions. The first solution tries to tackle the problem of economic rent, the second solution tackles the problem of its privatization.

The first solution involves increasing competition by eliminating entry and exit barriers if possible. This eliminates the monopoly rent.

If eliminating market barriers is not possible, the presence of economic rent is unavoidable, but its privatization can be avoided. Hence, the second solution involves the public distribution of economic rent, through a tax and dividend. The government can tax the earnings of the economic rent, or can auction the scarce positions to the highest bidders, and the tax and auction revenues can be distributed as a universal dividend or basic income. This unconditional, universal basic income reflects the justice idea that everyone has an equal right to the value or benefits of all the things that are not privately earned, such as talents, or personally created, such as natural resources.

As with monopoly rents, a lot of taxes generate an excess burden or deadweight loss, resulting in lower productivity and hence lower economic welfare. But the taxation of pure economic rent is an exception: it does not result in lower productivity. The reason is that the tax is levied on the part of the supply or demand curve that is vertical (inelastic). The total tax income is the grey area in the above figure.

If the tax rate is higher than the maximum to capture all pure economic rent (the difference between P_MAX and P_MIN), a deadweight loss is generated, as can be seen in the figure below. The grey area is the total tax revenue. The area between the corner points A, B, C and D is surplus value (economic wealth) that is lost due to the tax. With such a high tax rate, people have an incentive to supply and demand less of the factor of production. The total supply is Q’, which is lower than Q_MAX. Looking back at the definition of economic rent, the price earned by the owner (P’ in the figure) is lower than the minimum payment required to induce the owner to bring the full production factor into production.

This discussion of taxation allows us to give another definition of economic rent: the received benefit to an owner of a scarce factor of production that can be taxed without efficiency or productivity loss, i.e. without decreasing the supply of the production factor further below the socially optimal (Pareto efficient) level. For example, a monopoly supplies the production factor below the social optimum, but taxing monopoly rent does not decrease the supply even further below the optimum. A polluter (with external, environmental costs that are not internalized in the price) supplies the production factor above the social optimum, and taxing it (a Pigouvian taxation) can bring supply to the optimum level. Hence, the revenue from a monoploy rent tax and a pollution tax measure the economic rent of the monopolist and polluter.

 

Examples of solutions

Let us consider a few concrete solutions to the problem of privatized economic rent. First, we can eliminate economic rent by eliminating market entry and exit barriers. Some professions are licensed, which means there is an institution that can limit the number of licenses. Think about lawyers, notaries and medical professions. Those who are able to hold a position or receive a license can demand higher wages and salaries. Those revenues are higher than what is needed to cover all the opportunity costs of those professions, which includes the years of training. This is a kind of rent seeking behavior of guilds that can be prohibited.

On a much larger scale, we can think about open borders. Due to a policy of migration restrictions (closed borders), the global labor market is not in equilibrium. That means workers in high-income countries earn an economic rent: their real wages are 4 to 10 times higher than the real wages of equivalent (equally educated and skilled) laborers for equal work in low and middle income countries. This is much larger than the gender pay gap. Next to this injustice (unequal pay for equal work), there is a huge efficiency loss. With open borders, world income (gross world product) could roughly double. This is much more than liberalizing global capital and product markets. The global policy of migration restriction is probably one of the biggest examples of privatized economic rent. The size of the economic rent can be calculated as the total maximum willingness to pay of the native population to the rest of the world for keeping the countries borders closed.

A closed border policy increases labor market power and hence economic rent of domestic employees in rich countries compared to foreign workers who want to migrate. However, those employees in rich countries are themselves also victims of market power of employers. As it is often rather difficult to switch jobs (more difficult than e.g. choosing another brand of breakfast cerals in the supermarket), employers have a monopsony power: the labor market has many suppliers (workers, potential employees) and few buyers (employers who buy the labor of the workers). A monopsony in the labor market can create a total economic productivity loss (deadweight loss) of more than 10% of GDP and increases income inequality by decreasing wages and increasing firm profits and unemployment: the labor share of total output decreases from more than 70% to less than 60%, whereas the monopsony profit share of employers (the extra share of output that firms obtain because of monopsony power rather than their productive activities) is more than 10% (see Naidu, Possner & Weyl, 2018). Eliminating monopsony power in the labor market by antitrust remedies can therefore increase employment, economic growth and (low-skilled) wages with more than 10% and decrease income inequality with more than 10%.

If eliminating market restrictions is not possible, we can capture the economic rent. Consider a professional football player who earns a high salary because there are limited positions in the major football leagues. If the income of that football player is taxed a little bit, for example if that player has to pay a little bit to receive a license to play the next match, he or she will probably still play that match, even if the earnings are a bit lower. However, if the tax rate (the cost for the license to play) is very high, the player will decide not to play anymore and look for another job or something else to do during those hours of the match. In this case, the earnings of the player are lower than his or her opportunity costs. As the fans want to see the player play the next match, but the player decides to do something else, there is an efficiency loss because the fans lose some welfare. The maximum efficient tax rate or the maximum efficient price for the license will be such that the income of the player is barely above the opportunity costs, such that the player has the same incentive to play the match and the tax revenues for the government are highest. At this maximum efficient tax rate, everyone’s choices will be the same as without the tax: the player chooses to play the match. There are no incentives that lower productivity.

The same goes for owners of a natural monopoly, i.e. a monopoly that cannot be avoided by eliminating all market barriers. The government can auction the right to operate the business of a natural monopoly for a certain time period to the highest bidder. The auction revenue will capture all the monopoly rent of the business for that time period. The highest bidder is most likely the one who can most efficiently or productively run the business.

A land value taxation, proposed by the economist Henry George, is another example to capture resource rent. The land value captures all the economic value created by nature, not the added value created by people. The revenues of such a taxation can be distributed as a universal dividend. A related proposal to capture resource rents and distribute them to everyone, is the oil to cash idea.

A carbon tax and dividend and a fair and efficient cap and trade system for emission permits of greenhouse gases are two other examples to capture and distribute resource rents, in this case the value of the CO2 absorption capacity.

Finally, perhaps the most far reaching and universal taxation mechanism, is a Common Ownership Self-Assessed Tax (COST) or Harberger tax. The idea goes as follows. An owner of a property (e.g. a piece of land or a license for a position) should publicly declare his or her reservation price of that property: the lowest price at which the owner is willing to sell the property. This reservation price reflects the self-assessed value to the owner. If someone else is willing to buy the property at a price at or above this reservation price, the owner has a duty to sell the property.

Of course, in order to maximize profits by selling the property, the owner could declare a very high stated reservation price, much higher than the real reservation price (the real self-assessed value to the owner). However, there is a catch. If the probability that a potential buyer appears on the market in a given time period (e.g. a year) is p%, the average time that the owner can keep its property before selling it is 1/p time periods (years). The value for the owner for one time period is therefore p% times the total self-assessed value. If there are no opportunity costs and no incentives for investments in the property, the value of the owner equals its economic rent for that time period. The government can tax this rent, so if the owner wants to keep its property for a time period, he or she has to pay p% times the total self-assessed value as a tax to the government. This tax at a rate of p% can be considered a license fee that the owner has to pay for a property right to use the property for one time period. If the owner declares a very high stated self-assessed value, the owner has to pay more taxes. So these taxes are a means to keep the stated self-assessed value as low as possible. Combined with the preference to maximize profits from selling the property, the owner has an incentive to declare his or her real self-assessed value: not too low and not too high.

If the tax revenues (i.e. the total value of the property) are distributed as a universal dividend and if everyone can buy the property at the self-assessed reservation price, the self-assessed tax turns the private property in a kind of common ownership property. Hence the name common ownership self-assessed tax.

This tax system has several advantages. First, it captures the economic rent of owning private property. Second, it improves allocative efficiency: property more easily goes to the highest bidder, the buyer who values it the most or can use it in the most welfare productive way. One further nuance is important, however. Most properties are a mixture of natural resources and own personal investments. Think of a real estate that consists of the land (a natural resource that is not created by people) and a building that is created by people. If one risks having to sell a property, one has less incentives to invest in it, to increase its value by improving it. A p% tax rate will be optimal for allocative efficiency, but suboptimal for investment efficiency: it is too high to incentivize people to improve the property. If people invest in property, less than p% of the value of that property consists of economic rent (by definition of economic rent, which refers to the incentive of the owner to bring the property or production factor into production). This means that with improved property, the tax rate should be less than p%. It is possible to calculate for each type of property the optimal tax rate that optimizes both allocative and investment efficiency.

The self-assessed tax is an elegant method to deal with the two characteristics of a private good: excludability and rivalry. A good or service is excludable if it is possible to prevent people who have not paid for it from having access to it. The owner of an excludable property can exercise private property rights. With the self-assessed tax, the fact that the owner has to pay a tax based on the reservation price means that the owner has an incentive to declare a sufficiently low reservation price. As this increases the probability that a buyer is willing to buy the property at that low reservation price, and the owner is obliged to sell the property, it means that the property becomes less excludable.

Similarly, a good or service is rivalrous  if its consumption by one consumer prevents simultaneous consumption by other consumers. With the self-assessed tax, the fact that the owner has to sell the property to a buyer who pays more than the stated reservation price means that the owner has an incentive to declare a high reservation price. The property creates more value, and this higher value is distributed to other people through the self-assessed tax. It is as if more people can consume more (of the value) of the product. This means that the property becomes less rivalrous.

The abovementioned other taxes, such as the carbon tax, can be considered as special cases of the common ownership self-assessed tax. Such a carbon tax is comparable to an auction system where tradable emission permits are auctioned to the highest bidders. The rate of the carbon tax should induce a level of carbon emissions that equals the total level of emissions corresponding to all the auctioned emission permits. In this case, the price of a tradable emission permit equals the carbon tax rate. An emission permit is a property right, the right to emit a unit of greenhouse gases and use a part of the Earth’s absorption capacity. However, such an emission permit can be used only once: if the amount of gases are emitted, the emission permit expires. This is like a depletable resource or a consumption product that can be consumed only once (such as food). Hence, after one time period, after the permit expires or the product is consumed, the permit or product loses its value to the owner. It is as if something (nature) bought the product from the owner. Hence, the probability p to sell the property after the first time period of consumption is 1, so the self-assessed tax is 1 times the self-assessed value, which is the price of the emission permit.

Support for organizations

Several organizations focus on eliminating avoidable economic rents from market barriers and publicly distributing the unavoidable economic rents.

Open Borders and Free Migration Project promote open borders and the elimination of migration restrictions (which are very severe entry and exit barriers to labor markets).

The International Union for Land Value Taxation promotes a land value tax.

Citizens’ Climate Lobby promotes a carbon tax and dividend. Carbon Market Watch wants to improve the cap and trade system of tradable carbon emission permits.

The Center for Global Development promotes the idea of capturing resource rents from oil to be distributed as a dividend (cash transfers).

Positive Money promotes the idea of capturing the monopoly rent of commercial banks, by criticizing the system of fractional reserve banking.

The RadicalxChange Foundation promotes a common ownership self-assessed tax.