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 19th and early 20th 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.


Anonymous,  Wednesday, December 26, 2007 at 10:09:00 PM CST  

Ma-day´-lee: "Of all the proposals, [the FairTax Act, HR 25] violates just about every one of Smith's maxims."

Okay, Johnny, let's inspect your decided bias against the FairTax:

Smith's Maxim No. 1: "Taxation should be proportional to income.

FairTax: Families spending at the poverty level pay -0- consumption tax. (What's more, families have options under FairTax to ensure that this is so, where under the present system, their money is confiscated from their paycheck even before they see it.) As citizen-families begin to spend up from the poverty level, their level of taxation rises approaching a maximum of just below the 23%. If the rich are not citizens, then all of their non-business retail spending is at 23%.

There are no tax shelters under FairTax. There is no privileged class. At the same time, entrepreneurship is encouraged because job creation is not penalized by confiscation of working capital and payroll tax liabilities with every new hire; at the same time, the social safety net is neatly controlled through updates to poverty-level consumption by the Dept. of Commerce.

Certainly meets maxim requirement.

Smith's Maxim No. 2: "A tax ought to be certain and not arbitrary.

FairTax: Everybody pays at the same rate. The rich person buys more, and pays more. Certainly meets maxim requirement.

Smith's Maxim No. 3: A tax ought to be levied at the time and manner in which it is most convenient for the contributor to pay it.

FairTax: It's paid at the cash register. FairTax rate and amount are right on the receipt. Certainly meets maxim requirement.

Smith's Maxim No. 4: The cost of collection should be as low as possible.

FairTax: The store-keeper, or service provider, is paid a collection rate. The more s/he collects, the larger their pay for same. Since 80% of merchandise are sold by "big box" companies, it is unlikely that they'd conspire with purchasers to defraud. Enforcement is more local by turning it over to the states. And collection innovation is possible by the states sharing collection methods and systems (rather than a gargantuan, lumbering central collection agency that has not been able to plug a huge "tax gap"). Certainly meets maxim requirement.

Nonetheless, you've stated that,

"Of all the proposals, [the FairTax] violates just about every one of Smith's maxims."


The FairTax's progressivity is truly fair, based in equitable, and equal-opportunity, "wealth ladder" ascension. But the best part of the FairTax is that the Lords of Washington will find it difficult to screw with!

John Médaille Wednesday, December 26, 2007 at 10:28:00 PM CST  

Ian says, There are no tax shelters under FairTax.

On the contrary, there are many tax shelters in your plan:
1. Consumption which can be hidden as a "business expense" is not taxed (a popular dodge even in the current system.

2. Purchases of "used" items are not taxed.

3. Income not converted to consumption is not taxed.

4. Items bought overseas are not taxed (unless you are proposing import duties--so much for free trade).

In point of fact, you have proposed a "tax plan" that is, from the standpoint of the rich, composed almost entirely of tax shelters. For the rest there will be no escape; they must convert their income to purchase, and will be taxed at a rate much higher than the rich when the rate is figured as a percentage of their incomes. You fail all of Smith's tests.

Now, once again, let us deal with the questions you refuse to answer (well, a few of them--the blogsites are limited to a few gigabytes of storage on messages).

1. Why will the Arabs and Hugo Chavez lower the price of oil because we switch to a consumption tax?

2. How will the massive fraud (which Smith points out for a tax of this type) affect your "revenue neutral" calculations?

3. How will you fund the massive bureacracies that will be required for this plan?

4. Since you are taxing government purchases, what about the $300 Billion tax increase that this plan will require for state and local governments.

And so forth. You simply will not answer these questions because you have no answers. This plan will relieve the rich of most taxation, burden the middle class, and establish a massive welfare program that itself, besides being the most intrusive bureaucracy yet devised, will itself be the subject of massive fraud, and hence of massive increases in the police powers of the state to combat the fraud.

Instead of answering the questions, you stoop to insult. It is the sure sign of intellectual bankruptcy. That's okay; you are what you must be. But you are trying to extend bankruptcy to everybody, and that's not okay.

John Kindley Thursday, December 27, 2007 at 9:47:00 AM CST  

John, I was debating the Georgist "Single Tax" / Smith's "ground rent" with some Democrat-leaning friends of mine the other night and one of them asked about what happens when the developer puts in the mall right next door to the family homestead and now the ground rent for the family homestead becomes unaffordable. Nor would the family benefit, as they normally do in similar situations under the current tax regime, by being able to sell their property off for a much higher price than they paid for it, since the value of the underlying land would be absorbed by the ground rent. I was wondering if you had any thoughts on this situation.

I'm also aware of the view that Catholic Social Teaching actually had its original impetus, in Rerum Novarum, as a reaction to what Leo XIII saw as the "socialism" of Henry George and his "Single Tax" on the unimproved value of land. You have suggested before that you thought that the Georgist single tax idea was fundamentally correct but not complete, but Henry George in a long open letter to Leo XIII (to which the Pontiff did not deign to respond) argued that Rerum Novarum itself was incomplete in its opposition to the idea that the land and other natural resources belonged to everyone born into society equally and the private appropriation of such resources to the exclusion of others should therefore be taxed accordingly. Who do you think was right?

Anonymous,  Friday, December 28, 2007 at 5:15:00 AM CST  

"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."

You'd think so, wouldn't you? But in fact there is a hidden assumption here, one that isn't true always and everywhere. More importantly, it only partly applies in the modern western world.

That assumption is that the demand for lower wage labour will stay high enough to absorb all who need it. It is quite possible for wage levels to rise as you describe, but for some of the former workers to be squeezed out. That forms an external cost, with the additional unemployed either being covered by welfare systems or - in countries without enough of those - adding to vagrancy costs, which flow through to costs of policing etc. Since payroll costs don't rise as much as they would if all the former workers remained, the costs passed on to consumers don't rise so much either. But since the yield of the tax is also lower, it is hard to tell in advance whether more or less than 100% of that actually ends up being paid by the consumer. It all depends - but you definitely get the additional external costs if it pushes up unemployment (which also depends).

In case anyone is interested, I have some articles on this general area at my publications page.

John Médaille Friday, December 28, 2007 at 1:56:00 PM CST  

John, I hope that a Georgist will step up to answer your first question. As for the relations between George and the Vatican, I don't seen any evidence that Leo was responding to George specifically. Rather, he was responding to the general socialist drift of the time. I do think that Leo and George got each other wrong, and that George should not have rejected the distribution of property, nor Leo reject George's central premise. In my opinion, the two views are not merely compatible, but complimentary.

John Médaille Friday, December 28, 2007 at 1:59:00 PM CST  

P. M. Lawrence correctly points out that higher consumption taxes could raise unemployment rather than wages. This is correct. Smith is looking at the "best-case" scenario, assuming an absolutely free market with no frictional elements and no way to externalize costs.

Anonymous,  Saturday, December 29, 2007 at 4:20:00 AM CST  

'...Smith is looking at the "best-case" scenario, assuming an absolutely free market with no frictional elements and no way to externalize costs.'

That's not a sufficient condition to avoid upward pressure on unemployment, though it brings it closer. Think about it: if it were enough, there would be no point to Distributism. What is needed is the availability of alternatives that the low paid workers could move into, which wouldn't necessarily be available even with this condition if there were something structurally unbalanced.

Distributism suggests one arrangement to address such structural unbalances, Georgism another (though in my view not enough unless land really is being held out of circulation in the amounts needed), Basic Income yet a third (provided it is set at a level below subsistence that is still high enough to allow everyone to price themselves into adequate employment even at those lower top up wages). My own suggestion was to use a wage subsidy-like Negative Payroll Tax, at least to start with, because it is more fast acting - particularly starting from the position of a country like Australia where I am, with a GST and a welfare system. But all approaches fail if you ever reach a Malthusian catastrophe (and an NPT might delude politicians to allow that eventually, from not feeling the pain).

I should point out, it is a misunderstanding to think that taxes on labour work through to fall on consumption, even in the ideal case. They work through to fall on production, which in turn flows through to fall on consumption and on investment (plus government spending, plus exports, minus imports - but these adjustments probably aren't material for present purposes).

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