Taxes: Advice from Adam Smith

Third in a four-part series

When considering any subject relevant to government and economics, I always like to consult Adam Smith. Now, there are many who would disagree with this. Smith gets attacked from both the right and the left, usually for all the wrong reasons. Worse, he gets “defended” for all the wrong reasons; his “supporters” often attribute to him opinions he never held and against which he used his strongest arguments. For example, Smith was not a mindless supporter of “big business,” but in fact fulminated against it. For more on this theme, see my The Forgotten Agrarian: On Rereading Adam Smith. It may be Smith's fate to be among the most often quoted but least actually read of the modern philosophers.

It is not that I consider Smith infallible, but I usually find him sensible, and even when he is wrong or incomplete, he usually highlights the correct issues. In Book V of the Wealth of Nations, Smith has an extensive discussion of taxation, one that still serves us well today. Smith begins his discussion by laying out four maxims by which any particular tax can be judged.

The Four Maxims

• Taxation should be proportional to income. Smith seems to mean this in a negative sense, namely that taxes should not be regressive, because he praises taxes that fall disproportionately on the rich.

• A tax ought to be certain and not arbitrary. That is, “The time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor and to every other person.”

• A tax ought to be levied at the time and manner in which it is most convenient for the contributor to pay it. For example, a tax on rents ought to be paid when the rent is paid and not before.

• The cost of collection should be as low as possible. Under this heading, Smith includes four points:

1. The tax should require as few “officers” as possible to collect it.

2. It should as low an impact on industry as is possible.

3. It should create as few temptations to evasion as is possible. Where temptations to cheat are high, the law should be lenient.

4. A tax should not be such as to subject the people to “odious investigation” of their affairs.

Using these four maxims, Smith examines a wide variety of taxes. We shall confine the discussion to those taxes most relevant to our situation, income, sales, and land taxes. One note about Smith's methodology: he discusses issues based not only on theoretical considerations alone, but examines, in great detail, actual examples of taxes as they function both in England and other countries. His method, therefore, is a combination of theory and practice, which saves it from the dry abstractions of the Austrians as well as the pointless empiricism of Chicago School Friedmanites.

Taxes on Labor and Incomes

Taxes on lower wage workers can only have the effect of raising wages sufficiently to accommodate the tax. This is because a worker needs a certain amount to live, and will not work for less than that. Hence, a tax on low-wage labor is, in effect, an increase in the cost of production and is passed on to the consumer.

When a tax is levied on profits fall, for Smith, into two parts, a tax on interest and a tax on the labor of the entrepreneur. The entrepreneur must earn enough above the interest to make his living, or he will simply cease operations. Thus a tax on his profit about interest is equivalent to a tax on labor. A tax on interest payments, however, cannot have any effect on the rate of interest, since that will be set by the market. However, a tax on interest has two problems: one, the amount is difficult to ascertain (this was before the extensive reporting requirements of the modern era), and; two, capital is mobile, and high taxes will cause it to seek other climes.

In all cases, a tax on incomes must involve a severe inquisition into the circumstances of private persons. We all understand what that means. For myself, I do not object so much to the paying of the tax (which Smith regards as the duty of a citizen and the badge of a free man), but to the “severe inquisition” of the tax filings.

Consumption (Sales) Taxes

Smith divides consumption taxes into two parts: that on necessities and that on luxuries. By necessities, he does not mean “the poverty line” or what is merely necessary to sustain a man in subsistence, but that which is necessary for him to participate in a meaningful society. Smith uses the example of shoes. In some societies, it is perfectly acceptable to go barefoot, but not in England. A man who goes barefoot to a job interview in England (or America) is not likely to get the job, is not likely to be counted as a full participant in his society. Therefore, necessities for Smith means a lot more than subsistence.

A tax on necessities works in exactly the same way as a tax on labor. By raising the cost of necessities, one must necessarily raise the cost of labor by the same amount, with the difference passed on to the consumer. The consumer therefore gets a double whammy: an increase in the price via the taxes and an increase in the cost by the necessary rise in wages.

As for a tax on luxuries, Smith has little objection. It will discourage useless consumption by the poor and derive revenue from the rich. But all such taxes are difficult to enforce and the higher they are, they more they encourage what we would call “black markets”. Sales taxes, when they are high, often lead to lower revenues for the government, since the cost of collection is high and the inducement to fraud even higher. Smith's intuitive division of sales taxes into necessities and luxuries is recognized by most taxing authorities, which exclude things like food, housing, medicine, etc. And the taxes are kept relatively low so that the cost of avoiding them will not exceed the cost of paying them.

Taxes on Land

Smith distinguishes between agricultural land and land used for buildings or houses. I will not here take up his discussion of agricultural land. As for developed land, Smith divides the rent into two portions: ground rent and rent paid for the improvements. Any amounts above what gives a reasonable profit on the improvements goes to ground rent.

Ground rent is likely a new concept to many people, but it was of extreme importance in the economic debates of the 19^th and early 20^th centuries. Smith, Ricardo, Mill, Marx, Marshall, Walras, Clark, Senior, Henry George, and many other luminaries debated the issue at great length. Unfortunately (from the standpoint of a complete economic theory) the subject died after J. B. Clark subsumed land into the general “capital fund” theory. Ground rent is the price or rent of land that underlies any improvement on it. It rises with the population of the surrounding area. That is, a parcel of ground in a densely populated city will cost more than than an equally good parcel in a smaller city, which will cost more than a similar parcel in the country. In other words, it is not anything the landlord adds to the land, but what others add to it that raises the ground rent. Peace, prosperity, and population increase raises the price of land without the landlord actually having to do anything. Such increases in the rent or price of land are unearned increments, involving no effort whatsoever on the part of the owner.

For this reason, Smith found that ground rent was the most appropriate subject of taxation.

Ground-rents...are altogether owing to the good government of the sovereign....Nothing can be more reasonable than that a fund which owes its existence to the good government of the state, should be taxed peculiarly, or should contribute something more than the greater part of other funds, towards the support of that government.

Taxes on house rents, Smith held, would fall most heavily on the rich, but he held that to be an advantage. It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.

To sum up, we can arrange Smith's taxes in order from most appropriate to the least in this way: taxes on ground rent, house rent, luxuries, incomes, and necessities.

From Smith's principles we can evaluate the tax proposals before us. Of course, the present system of reliance on income taxes violates most of Smith's principles. However, the most touted alternatives are generally worse. The Flat-tax involves all the inconveniences of the current system, plus makes the system highly regressive. This is because it maintains, on top of the flat tax, the FICA taxes, which will give most people a much higher marginal rate than they currently have. However, FICA stops at about $90,000, which means the marginal rate for the highest incomes will be cut in half. The middle class will pay the marginal rates of the rich, while the rich will pay the marginal rates now paid by the middle class. It is hard to think of a tax plan more poorly planned or more unfair.

Unless it is the “Fair” tax. For the majority of people, who must convert all or most of their incomes to consumption, it will function as an income tax with high marginal rates. For the rich, who convert less of their income to consumption, it will be a tax reduction, while for the very rich it will come near to tax elimination. In addition, it will require massive collection and enforcement bureaucracies and encourage cheating on a massive scale. Of all the proposals, it violates just about every one of Smith's maxims.