The Online Library of Liberty

A project of Liberty Fund, Inc.

• Preface
• Note.
• Wealth
• Chapter I: The Subject-matter of Economics
• Chapter II: The Fundamental Conditions of Wealth For Isolated Man and For Society
• Chapter III: Co-operation, Or Combination and Division of Labour
• Chapter IV: Population
• Chapter V: The Social Order
• Chapter VI: The Controlling Power of Demand
• Chapter VII: The Control of Provision For the Future
• Chapter VIII: Continuous Power to Demand, Or Income
• Chapter IX: The Classification of Incomes
• Chapter X: The Division of Income Between Owners and Workers
• Chapter XI: Incomes From Ownership of Property
• Chapter XII: Incomes From Work
• Chapter XIII: The Relation Between Individual Income and Individual Wealth
• Chapter XIV: The Wealth of Nations

CHAPTER IX

the classification of incomes

The classification of incomes which is found most convenient for purpose, of economic exposition naturally does not remain always the same. It changes with changing social conditions. That which was convenient in England in the eighteenth century would not have been very enlightening in India at that time, and is not very suitable for English use in the twentieth century. But tradition connected with it still plays such a large part in forming the thought of the present time that it would be useless to ignore it.

It was a threefold classification into wages, profits, and rent, which corresponded very well with the social stratification of the time and place. In the country the labourers were a fairly well-defined class receiving wages and nothing else, the landlords another fairly well-defined class receiving rent and nothing else, and the farmers another such class making profits and having no other income. In the towns, it is true, the profit-makers in the shape of merchants and manufacturers often owned the land on which shops, counting-houses, and factories were built, but this was regarded as a small matter which did not suffice to turn them into “landlords,” as the rental value of their premises would be generally trifling in proportion to their gains as “monied men.” and in towns was practically ignored: the “labourers” in towns were in just the same position as in the country, so that the classification of income into wages, profits, and rent seemed to fit the national classification of persons quite satisfactorily. Moreover, it seemed to be suitable for explaining the organization of production prevalent in England at the time. In the country the produce belonged to the farmer, and he looked to it to recoup him for what he spent in wages and rent, which were regarded as constituting together practically the whole of his expenses. Merchants and manufacturers certainly had to purchase materials and goods, but what they laid out in this way might be treated as ultimately replacing what had been spent in wages and rent by some farmer or manufacturer who produced the materials or goods in question. The threefold classification was introduced into economics by Adam Smith, and it seems probable that he hit upon the idea while attempting to analyse prices into their component parts. “Market price,” or the fluctuations of price in the market, depended, he thought, on supply and demand, but “natural price,” or price in the long run, depended on how much wages, profits, and rent had to be paid in order to secure the commodity. By what may perhaps be called a mere accident, he was led to convert this theory of prices into a classification of income. While he was thinking out his theory of prices in Scotland, there flourished in France a little school of economic and political theorists who were called at the time the Economistes, but who were subsequently, in order that confusion might be avoided, christened “Physiocrats” in consequence of their belief in the rule of Nature. The school was the product of a reaction from Colbertism, which had tried to bring prosperity to France by favouring manufactures and commerce. Its principal tenet was that agriculture, or at any rate the earth, was the source of all wealth, and its great revelation, regarded with amazing veneration by the elect, was the Tableau Economique or Economical Table, in which its founder, Quesnay, tried to show by a number of zigzag lines how the produce of the earth was “distributed,” as he called it, throughout society. On making acquaintance with this scheme, and seeing the immense importance which the physiocrats attached to the “distribution” which it was supposed to portray, Adam Smith seems to have resolved to treat his own analysis of prices into wages, profits, and rent, as also a classification of incomes. He said that just as the price of any particular commodity resolves itself into one, two, or all three of the three component parts, wages, profit, and rent, so the price of all the commodities which compose the whole produce “must resolve itself into the same three parts, and be parcelled out among different inhabitants of the country, either as the wages of their labour, the profits of their stock, or the rent of their land. The whole of what is annually either collected or produced by the labour of every society, or what comes to the same thing, the whole price of it, is in this manner originally distributed among some of its different members. Wages, profit, and rent are the three original sources of all revenue as well as of all exchangeable value.”

The three terms, wages, profit, and rent, seem to have been used in the ordinary conversation and literature of Adam Smith's time very much as they are at present. Wages meant what was paid to persons for their work when they were paid at a rate agreed on before the commencement of the work, and when they worked more or less under the supervision of the employer; rent meant the periodical payments made to the “landlord” by a tenant of land and anything affixed to and let with the land, such as hedges and ditches and houses; profit meant any net gain arrived at by deducting expense incurred from gross receipts. Roughly speaking, no doubt, it could be said that labourers lived on their wages, landlords on their rents, and farmers, merchants, and manufacturers on their profits. But certainly the three words, as ordinarily used, have always included some receipts which lie outside income and do not include the whole of those which lie inside it. The contracts under which the great bulk of rent is paid do not secure the landlord “a clear annual rent without any deduction whatever”: he has usually to expend an appreciable proportion of his rent in keeping the property in a rent-yielding condition, so that the income derived from the property is appreciably less than the rent. The wage-earner likewise has often to pay out of his wages some necessary expense of the work which he does, as when he provides his own tools. On the other hand, the three terms do not together cover the whole of income, as there are many other receipts of which the whole or part forms or contributes to the income of those who receive them. There are, for example, salaries received by workers of a higher class than those who are said to receive wages, fees received by others who are less subject to supervision by their employers than wage-earners and receivers of salaries, as well as fines, dues, royalties, and other payments received by owners of property. In the passage quoted Adam Smith ignores all these discrepancies: he alleges explicitly that the three categories taken together include the whole of income, and he implies that they include nothing else. What he was really doing, without clear comprehension of the fact, was defining labour, stock, and land so that together they would include all sources of income, and defining wages for his purposes as income derived from labour, profits as income derived from stock, and rent as income derived from land.

He admits in subsequent paragraphs that “common language” does not always agree with his definitions: a man cultivating his own land, he says, will call the whole of his gain “profit” without allowing anything for rent; a tenant farmer who supervises the work of the farm and even assists with his own hands will call all that is left to him after paying working expenses and keeping up the stock “profit” without allowing anything to himself as the wages of his labour; an independent artisan who makes things for his customers instead of working under a master will also call his gains “profit” without making any allowance for wages; and finally, a working gardener who owns his own garden is “commonly considered” as receiving the “earnings” (not, be it noticed, the “wages”) “of his labour,” nothing being taken off and attributed to him as the profit of his stock or the rent of his land. But these observations did not suggest to his mind any doubt about the convenience of his definitions. He merely infers that “common language” is wrong, and that it “confounds” the different sorts of income. “When,” he says, “those three different sorts of revenue belong to 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.”

The weak point of this exposition is that it gives no example of cases in which “those three different sorts of revenue belong to different persons.” In fact, it is extremely difficult to find one. The large class of tenant farmers, on Adam Smith's own showing in the passage just quoted, receive “wages” in his sense of income from labour, as well as profits or income from stock, and in a later chapter he tells his readers that the greater part of the gains of a retail shopkeeper may easily be “real wages.” Wholesale merchants and manufacturers he seems to have regarded as receiving no appreciable amount as “the wages of a particular sort of labour, the labour of inspection and direction,” but, all the same, he seems to have supposed that about half their gains were due to some undefined exercise of activity, since he quotes with approval the common estimate that a fair profit is double the rate of interest. This estimate suggests at once the question why the income derived from the ownership of stock should be coupled up with the income derived from the owner's exertions by the whole being called “profits of stock” or of capital. Why not admit that the wholesale merchant and the manufacturer as well as the retailer and the farmer earn by their labour all that they get over and above ordinary interest on their capital?

For nearly a century after Adam Smith wrote, economists were prevented from taking this step by theories of wages which required them to believe that wages in the ordinary sense (agreed payments for labour executed more or less under the supervision of the employer) were regulated by principles entirely different from those which regulate other earnings of labour, in regard to which there is no contract of service. Though they formally defined “wages” as if the term were synonymous with income derived from labour, they always had in their minds wages in the ordinary sense, and the theories which they framed respecting wages could not be stretched to include the earnings of the labour of a person working on his own account. But when these theories crumbled away, the practice changed, and instead of “confounding,” as Adam Smith might have said, the income which the owner of capital derives from his activity and that which he derives from his property in the common denomination of “profits of capital,” economists began almost with one accord to call the income derived from capital “interest,” and to treat the other portion of the owner's gains as belonging to labour's share, though they have not as yet agreed by what special name to call it. The Americans usually call it “profits” simply, but English writers have hesitated about making so great a break with economic tradition, and have sometimes left the category nameless, and sometimes called it “earnings of management.” This last course is inconvenient, because it mixes up the gains in question, obtained by persons working on their own account, with the incomes of persons engaged in management but paid by salaries or wages.

By this division of Adam Smith's “profits of stock” into two shares, one for the active operations of the “undertaker of the work,” as he was called in Smith's time, and one (to be called “interest”) for the passive ownership of the property, a clear line was drawn between income from labour and income from property. But another question still remained, namely, how to distinguish “interest,” the share of “capital,” from “rent,” the share of land. Adam Smith himself seems never to have felt any need for careful distinction between land and what he called “stock.” To him land was land and stock was valuable property other than land: land brought in a rent, and the part of “stock” which he regarded as “capital” brought in a profit, and it did not occur to him that any one would have or make any difficulty about the matter. But even he admits that “the rent of land” may sometimes partly (and conceivably in some exceptional cases wholly) consist of “reasonable profit or interest” on capital expended on the improvement of the land. If we once admit that rent can owe its origin to the expenditure of capital in this way, we must admit that “land” can be increased in value by human labour expended upon it, and the sharp distinction between land, given by Nature, and capital, the accumulated product of past labour, is hopelessly blurred. Ricardo made a slight attempt to enforce purity of doctrine by declaring early in his Principles that he would apply the word rent only to what was paid for the “original” powers of the land, but he soon explicitly abandoned this proposal and drew a line between permanent and perishable improvements, classing the income from permanent improvements as rent of land and the income from “buildings and other perishable improvements” as profits of capital, or interest, as later writers would call it.

This second plan of Ricardo's was generally followed until the last decade of the nineteenth century. Then it was perceived that the distinction he favoured was not one of principle but only of degree; improvements are not divided into two kinds, one “permanent” and the other “perishable,” but may be better described as all more or less permanent or more or less perishable. Marshall brought the fact into greater relief by devising the term “quasi-rent” for the income derived from the ownership of appliances for production made by man, though he does not actually use it in place of the usual term “interest” for the income obtained from capital regarded as a share in distribution. Since that time it has been possible for the economist to give attention to the division between earnings of labour as a whole on the one side and the income derived from property, whether rent, quasi-rent, interest, or anything else, taken as a whole on the other side. This I propose to do in the next chapter.

Some reader may perhaps object to the division of all income into Income from labour and income from property on the ground that income is sometimes obtained from personal qualities without labour. The Siamese Twins and General Tom Thumb, he will say, got their incomes not because they laboured, but because they had certain rare peculiarities which made people ready to pay to look at them. It is doubtful, however, if there are any personal qualities which can be exploited without some amount of labour. Even the Fat Woman in a travelling show, who might be taken as the type of pure passivity, has to give up her time, and must find being stared at and commented upon quite an appreciable exertion. It seems unnecessary to split hairs over the question. If any one thinks it an improvement to substitute “income from labour and personal qualities” for “income from labour,” he is quite at liberty to do so. The change might make an important difference if there were any suggestion that workers get income because labour is meritorious, but there is no such suggestion in the present work.