Land Rent and Selling Price
In a free market, products exchange for a value equal to their cost of reproduction. Assets which cannot be reproduced, but yield an income (like a license to sell alcoholic beverages) are valued through a process called capitalization.
Parcels of land fit in this category. Because they cannot be produced, their price cannot be determined by cost of reproduction. So, the selling price of a parcel of land is based on a comparison between the potential income from that land and the amount of capital that would be needed to yield a similar income. This process, called "capitalization," is standard in real estate circles.
However, the income from a parcel of land tends to increase faster than the income from the ownership of capital. In that case, if the owner of a parcel of land agreed to sell it for a price based on its current income, she would forego the increased profits which would accrue over time.
Seems like a pretty good deal, but... if the house
came to be sold for $150,000 four or five years
from now, would the land still be free?
Although land is usually offered for sale at an advertised price, it is generally sold for less to the highest bidder. And it is rarely sold for a price based on its potential to yield an income in the present. The buyer will tend to be the person with the greatest expectation of the site's future profits.
There is no way to predict with certainty what the rental income of a site will be in the future. Therefore, there is no existing set of facts from which to precisely calculate what anyone will pay for a parcel of land in the present. In times of land booms, when land prices are rising rapidly, this prediction gets less and less precise.
The process of capitalization also depends on the interest rate. Essentially, the annual rent of a site is divided by the current rate of interest, and this capitalized rent is the basis for the selling price (most often a speculative premium is added). Thus there tends to be an inverse relationship between the rate of interest and the selling price of land. That is simply because, if the interest rate is lower, more capital will have to be invested to yield the same annual income. Therefore, if the central bank lowers interest rates, this means that the divisor — the capitalization rate — is a lower figure. Land prices will increase.
As the selling price of land gets bid up higher and higher, owners of unused land become that much more tempted to hold their land out of use. Then businesses find it more profitable to down-size, rather than expand their productions. As the unemployed workers buy fewer products, the reduced demand reverberates throughout the economy and a recession/depression is under way.
If the entire rent of land were taken in taxation, there would be no rental income, hence nothing to capitalize, and no selling price. A 100% tax on land rent would destroy the selling price of land, and thereby destroy any profit that could be had from land speculation.
This fact has led some critics to complain that because a 100% tax on land values would destroy land's selling price, this revenue source would be impracticable, because it would destory its own tax base. This criticism ignores the difference between selling price and rental value. The selling price is derived from the rental value, and based on the ability to keep collecting that value on into the future. If the rental value were fully collected by the community, there would be no rent to collect in the future, and therefore no selling price. Nevertheless, land would still have a rental value, as long as people were willing to pay for its use. If the overall economic climate improved, the land's rental value would increase.
Henry George advocated collecting something less than 100% of the rent of land. He recommended that a small percentage, say 5%, should be left to the landowner, which would in turn be capitalized into a selling price (albeit a much smaller one). The advantage of this would be to ensure that free-market forces set the value of land, and to keep government out of the business of making land-distribution decisions. However, today's real estate appraisers employ well-established techniques for estimating land values, whether the land is improved or not. This leads many Georgists to argue that public collection of the full land rent would indeed be feasible.*
*See "Estimating Land Values" by Ted Gwartney.