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.