“Economic capitalization” is the conversion of a flow of income into a stock of value. This is also referred to as the present value of a future flow. Imagine a place that had a lake, but is now dry. A river starts flowing into the lake. If you measure the volume of river water per day, you would be able to measure how big the lake will be in a week. The water flow is capitalized into a stock or amount of water. If one were to sell the value of that water today, even before the lake is full, it would be the present value of the expected flow of water.
This is a different meaning than “market capitalization,” which measures the total value of a company or shares of stock. It is also not the financial meaning of the financing used by a firm.
Economic capitalization can be used to calculate the value of an asset based on its flow of net income, using a typical ratio of yield to asset value, the capitalization rate. Interest rates are often used for the capitalization rate, but the capitalization rate is not necessarily the interest rate, especially as there are various types of interest rates. There are short term and long term rates, and the nominal rate (the rate stated by the issuer) is different from the real rate, the nominal rate minus the inflation rate. Another complication is that what is called "interest" is often not pure interest, but includes a premium for risk, included in the capitalization rate.
Let's take bonds as an example. A bond is a promise to pay a particular amount of money per year to the holder, during some time interval, or term. Suppose the capitalization rate is the real interest rate, and the bond has no default risk, and there are no taxes. Suppose also that this is a perpetual bond that never matures, having an infinite term. Then the price of the bond equals the annual yield divided by the capitalization rate.
For example, if the bond pays a $100 return per year, and the real interest rate is two percent, then the price p equals the return r divided by the interest rate i: p = r / i. Thus the price of the bond is $100/.02 = $5000. If there is a tax on the bond, then either the annual tax is subtracted from the return, or the tax rate is added to the interest rate. Also, if the return is expected to increase at some constant rate, then the rate of growth is subtracted from the interest rate: p = r / (i - g).
This formula applies to any asset. The price of a share of stock is the capitalization of earnings, the present value of its future earnings or profits. And the price of land equals the expected flow of net rents (after paying expenses) divided by some typical capitalization rate. The capitalization rate for real estate in the USA has been around five percent, which includes risk as well as pure interest.
One of the most important occurrences in an economy is the economic capitalization of territorial benefits into land values. Amenities such as streets, highways, security, parks, schooling, and welfare payments make locations more attractive and productive, which raises the ground rent, and therefore gets capitalized into higher land values.
One of the most important occurrences in an economy is the economic capitalization of territorial benefits into land values. Amenities such as streets, highways, security, parks, schooling, and welfare payments make locations more attractive and productive, which raises the ground rent, and therefore gets capitalized into higher land values. As land has no cost of production, the market price of land is the capitalization of the net benefits of the location and the material natural resources, including the climate: rainfall, sunlight, and temperature.
This capitalization occurs because land is immobile and fixed in area. Factors that are fully mobile do not obtain such capitalization. If labor, for example, were fully mobile, so that workers could move at little cost, then if wages in location A are higher than in the rest of the economy for the same skills, workers move into A until the wage there falls to normal. Likewise, if cars sell for more in A than cars elsewhere because the demand rose in A, dealers would import cars until the price of a car no longer capitalizes the demand into extra profit.
So in the short run, other factors can gain from capitalization, but in the long run, when all inputs are variable, it is mainly land that gets capitalized from locational advantages. Just as benefits increase rent and land value, disadvantages such as crime and pollution get capitalized into lower site values.
As real estate is a major asset and a major cost for households and enterprise, the capitalization of territorial benefits is an important economic phenomenon. The net benefits of the public goods and civic services provided by government generate higher land rent and become capitalized into higher land values because most of the payment comes from taxes other than on that land value. A worker who is also a renter pays both higher rent and taxes for the public goods. If the worker-tenant is double-billed, someone is getting subsidized - the landowner. Owners of land obtain higher land value because their sites get services paid for by others, from taxes on wages, enterprise profits, value added, and the sale of goods.
This implicit subsidy constitutes a forced redistribution of wealth from workers to landowners. This redistribution is a major reason why wages have stagnated even while economies have kept growing. The higher rent is not recognized because most of it is masked in forms such as profits, interest, dividends, and taxes.
A tax on the land rent or value, such as by a property tax or an income tax on the rental income, gets capitalized down into lower purchase prices for land. If landowners pay for all the public goods, then there would no longer be an implicit subsidy to land value.
The capitalization of benefits into land value has another consequence: much of the gains from economic expansion, due to both better technology and more investments in education and capital goods, gets captured by higher rent and land value. The increase in real estate prices during an economic boom attracts speculators who create an unsustainable bubble that then crashes and brings down with it the financial sector, as happened in 2008.
The economic textbooks ignore the capitalization of public goods into land values. The public finance tests do mention it, but do not grasp the policy implications. Economists have largely failed to include capitalization in their theorems and mathematical models.
Yet, the economic textbooks ignore the capitalization of public goods into land values. The public finance tests do mention it, but do not grasp the policy implications. Economists have largely failed to include capitalization in their theorems and mathematical models (but see the note below). It goes back to the mathematization of academic economics into models of K and L, capital and labor, ignoring land for both mathematical convenience and the influence of landed interests who turned grounded classical theory into ethereal neoclassical modeling.
So the public does not understand capitalization, and neither do journalists and politicians. The tax debates are minor arguments over tax rates, exemptions, deductions, credits, and alternative calculations, rather than the big issue of why we capitalize the wealthy landed interests at the expense of labor, enterprise, and the poor.
Note: there have been a few scholarly articles on capitalization, such as “Land Value Capitalization in Local Public Finance,” by David A. Starrett in the Journal of Political Economy, Vol. 89, No. 2 (Apr., 1981), pp. 306-327.
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FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.
Foldvary is the author of The Soul of Liberty, Public Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.
Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.