Accounting (unearned) Profit vs. Economic (earned) Profit
Shedding some light on the confusing distinction between unearned profit (which should be heavily taxed) vs. earned profit (which should not be taxed).
September 16, 2018
Rick DiMare

The distinction between unearned profit (which should be heavily taxed) vs. earned profit (which should not be taxed) is a source of great confusion among Georgists today, so let’s try to shed some light on the difference. Below is a short article by Georgist Roy A. Foulke (1897-1994) that appeared in the Georgist Journal, October 2016.

Georgism would be making progress in understanding that Henry George’s definitions of capital, profit, interest, etc. in Progress and Poverty (1879) were designed to protect industrious productive activity from his “single tax,” but were not designed to support the privatization of corporate profits, or what we today call “unearned income.” For example, from Henry George’s perspective in 1879, if a farmer built a barn, bought a tractor, or improved his land, those capital goods should not be taxed, nor would George want to penalize the farmer for increasing yield and working more efficiently by employing these kinds of capital goods and improvements.

However, that does not mean, under today’s neoliberal or anarcho-capitalist view of things, that interest income, capital gains, and profits should be untaxed or lightly-taxed. In other words, George would not stand for the idea that a modern-day capitalists or corporatists who employ a few robots (physical capital) to operate a farm should be able to keep all the profits, as though the profits were a form of wages to compensate for the “skill” in deploying robots.  

Anyway, the following article appeared in the Georgist Journal, October 2016, issue #129, pages 39-40:

THE TYRANNY OF WORDS, Roy A. Foulke, retired vice president of Dun and Bradstreet, first appeared in the New York Daily News in 1949, and reprinted in the Henry George News in 1971.
“In WEALTH OF NATIONS, Adam Smith pointed out, over and over again, that all production is divided into three streams: one in the form of wages to employees, one in the form of rent to landowners, and one in the form of PROFITS to suppliers of capital.
These terms, as used by Adam Smith, carry connotations that are somewhat different from their meaning in our present-day industrial life.
In wages to employees is included payments to officers of corporations, to proprietors and to partners for their services, as well at to labor.
The payment of rent represents the return to the landowner on the value of the land in its natural state without improvements of any kind, and not the payment of a monthly or yearly sum, which today has generally come to include two payments, economic rent on the value of land, and a return on capital (i.e., the improvement).
Profit, according to Adam Smith, is the return to capital after the payment of all wages and the rent of the land in its natural state has been deducted from production.
Then Smith carefully observed, ‘When those three different sorts of revenue belong to three different persons, they are readily distinguished; but when they belong to the same they are sometimes confounded with one another, at least in common language.’
Because of the confusion in the term ‘profit’ as used by Smith in 1776 as the return to capital, and by the general public as the excess of income over cost, Henry George in 1879 decided to substitute the word ‘interest’ in place of the word ‘profit’ as used by Smith to represent return on capital.
It is possible that substitution in terms—though carefully explained with great clarity—has been the source of steadily increasing confusion in the mind of the pragmatic businessman. The ACCOUNTING PROFIT of business, representing the excess of income over cost . . . has nothing to do with economics.
Few business corporations were in existence in 1879.  Not until 1886 did the Supreme Court decide that a corporation was a person in the meaning of the ‘due process’ clause of the federal Constitution. That decision gave an element of unprecedented security to the existence of the large corporation, which was just becoming a dynamic power in our economic life.
In 1879, there was no firm of public accountants in the United States. The first of accountants of consequence was organized in 1883 in New York City.  It was not until 1896 that the accounting profession was legally recognized; it was then that New York State first granted certificates of qualification.
From the viewpoint of classical economics, it is understandable that we fail to ascertain reliable figures for aggregate profits (George would say ‘interest’ [Footnote: Fred Foldvary would say ‘capital yield’]) under the mathematics that is practiced today. The reason is that the ACCOUNTING PROFITS of corporations, which own land where some of their plants, warehouses or other installations are located, actually encompass ECONOMIC RENT.  Moreover we lack even a faint idea to what represents value on the value of land in its natural state and what part represents the return on capital invested in a business which includes improvements on the land.
What we run up against today is the confusing reality that ACCOUNTING PROFIT or the businessman’s profit, in addition to being a relative mathematical concept, is not ECONOMIC PROFIT or, in the words of Henry George, is not “interest.””  
Roy A. Folk (1897-1994)

The problem with the concept of "earned profits" (which should not be taxed) is that, like wages, they are relative to the person earning them, so in other words, there's no practical objective way to determine in advance how each businessperson should use a land parcel.

An assessor may be able to give a good educated guess as to what portion of the profits are a form of earned income (like wages) vs. unearned passive income, but in the end, we need to leave it up to the land parcel owner to determine and report what part of his profits are earned vs. unearned (and of course, if he ventures too far away from his industry norm, the IRS will have something to say about it, and force the reclassification of reported earned income to the unearned category).

As noted by Roy Foulke in the above article, accounting rules did not really develop until after Henry George died, and this includes depreciation rules, which George hinted at in The Standard as something that would assure that capital goods were not taxed.

In Feb. 1889 article Henry George said this:
"Another difficulty which may suggest itself is how are improvements, such as draining, grading, etc. whose value is generally merged into the value of land, to be separated from the naked value of land in the assessment of taxation. Where this could not otherwise be done, the best way would probably be to permit a deduction for a certain time of the then value of such improvements."

This comment by George suggests that after all capital goods have been properly depreciated, and everyone paid a fair and reasonable wage, whatever is left over is unearned "land value" or "economic rent" or what we call today "unearned income," which should be heavily taxed, not privatized.

An interesting problem arises in our technological era where capital goods (computers, robots, electronics, etc.) are becoming so efficient. Do these highly efficient capital items cause unearned "capital gains"?

I think it depends on the circumstances under which the income or wages are received or earned.

Under the Lockean/Georgist view of a worker owning his/her wage, for example, a lone farmer or fisherman using advanced technology (and a land parcel) would still be able to keep (untaxed) all that his/her labor produced, or what George would call "interest" (derived from the capital good).

But upon hiring people, or incorporating the business, there would be unearned gains because of the hiring of the workers (unless the workers were common law partners in the business). ... but in case of incorporation the Stone Tracy income tax is due whether or not the lone farmer or fisherman hired workers.

There appears to be two kinds of "interest" described by Henry George: (1) a good kind (that should not be taxed) that comes from capital "goods" and represents a natural increase in productivity from the use of tools, commercial buildings, land improvements, technology, etc.; and (2) the bad kind of interest that he and Thomas Shearman wanted to tax in their 1893 special income tax, the kind of "interest" that bankers charge to borrowers.

In reviewing the George/Shearman 1893 special tax on unearned income, it appears that only interest paid out by corporations on the bonds they sold were taxable.

Also, in Progress and Poverty (assuming honest money is being used by lender when lending to a borrower), if I understand him correctly, George would call some of the lender's take "compensation for risk," not interest.

In Book 3, Chapter 3, George says this:
"I have already referred to the difference in meaning between the terms profits and interest. It may be worthwhile, further, to say that interest, as an abstract term in the distribution of wealth, differs in meaning from the word as commonly used, in this: That it includes all returns for the use of capital, not merely those that pass from borrower to lender; and that it excludes compensation for risk, which forms so great a part of what is commonly called interest. Compensation for risk is evidently only an equalization of return between different employments of capital. What we want to find is, what fixes the general rate of interest proper? The different rates of compensation for risk added to this will give the current rates of commercial interest."

We are so far from an honest monetary system, this topic is almost irrelevant, but it can't hurt to keep considering the scientific reasoning used by George to define his terms.

Not to confuse the issue further, but I don't believe that our current-day meaning of "interest" (on the use of FRNs) would even be recognized or labeled by Henry George, except perhaps as impermissible usury.

He did not even consider bank bills (private debt) to be wealth or capital, so how could interest obtained from the loaning of bank bills be legitimate?

I think they call a "chose in action" because, like a check, you can't be sure if the bill will be good. A chose in action is not a final thing, but something in the process of becoming final.

But the current 1963 series FRN is not redeemable for anything. It's simply an unconstitutional "evidence of debt" which is not allowed under the Borrowing Clause. The Borrowing Clause demands that U.S. bank bills be redeemable in current coin to be a valid act of borrowing.

But I guess so long as nobody thinks the emperor is naked, he's not.

There are basically 3 kinds of that stuff called "interest," (1) a good kind of interest derived from capital goods (tools, buildings, inventory, land improvements, electronics, etc.) that causes more productivity; (2) interest on the lending of sound financial instruments; and (3) interest on the lending of unsound financial instrustments that are based on the FRN dollar, which is the kind most Americans have been experiencing since the 1960's.

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Rick DiMare

Rick is a self employed attorney from Boston, Massachusetts. He graduated from Boston College and studied law at the Massachusetts School of Law at Andover. He also administers the Facebook group called Common Wealth Tax, which seeks to explore the (currently obscure) link between modern income tax laws and the Land Value Tax (LVT) advocated by political economist and “Greenbacker” Henry George (1839-1897).