Thoughts on economics and liberty

Tag: Public Finance

Discovery of similarities between Adam Smith’s views on taxation and mine

A couple of years ago we had a number of debates within FTI re: taxation, and my views (see this and this – and this) were found by some members to be particularly strange, given the strong advocacy of consumption and corporation tax these days by most "experts".

I’m not a public finance expert (or expert in anything); instead I diligently derive conclusions from first principles. Everything must fit into a coherent whole, else it doesn't make sense to me.
Hence my views on taxation have been based, first, on a theory of existence, then on a theory of the state, then theory of social contract, followed by an understanding of human nature (tendency to free ride) and finally, pricing concepts such as the price discriminating monopolist. I won't repeat the theory which is outlined in the two articles of 2009 published in Freedom First, linked above.
After I had formulated my views, it did not surprise me to later find that Adam Smith had promoted broadly similar ideas in relation to progressive taxation. But that he held similar views on other taxes, as well, was something I've only discovered recently.
While browsing my copy of P.J. O’ Rourke’s book, On The Wealth of Nations, I came across a section on taxes which summarises Adam Smiths’s views on that matter. It turns out that the resemblance between Smith's views and what I wrote a couple of years ago is uncanny.
(Of course Smith came first, and in many ways is my "guru". So he must have 'influenced' my views. Alas, I'm afraid not, much as I'd have liked to. Never having sufficient time for extensive reading, even during my doctoral studies when I voluntarily took a course on political economy and thus happened to study Smith – note that Smith is NOT taught in economics courses these days), I have only managed to read Smith’s voluminous book in part. Instead, I have a couple of books that summarise Smith (hence O’Rourke’s book as well). It has therefore been convenient to have Smith's views on taxes neatly summarized by Rourke. 
Below is the relevant extract (and yes, I’d recommend O’Rourke book for your library).

‘Of Taxes’

Adam Smith did a lot of thinking about taxes, eighty-odd pages worth. He began with four sensible maxims of taxation: taxes ought to be inexpensive to collect, be levied when taxpayers are best able to pay them, be proportionate to the revenue that taxpayers ‘enjoy under the protection of the state’, and be ‘certain, and not arbitrary’. [Note: Smith's first canon of taxation was that tax be proportional to incomes: note this can imply a flat tax, although I demonstrate that a modicum of progression is more appropriate. Sanjeev]
The last maxim is the most sensible and therefore the least observed. The boggling complexity of tax law and the cease­less fiddling with taxes, even by legislators who would lower them, violate Smith’s principle that ‘a very considerable degree of inequality … is not near so great an evil as a very small degree of uncertainty.’ It’s a principle that applies to practically everything, as anyone who is in love or waiting for a check in the mail knows.
Smith was opposed to inheritance taxes, which are almost as arbitrary, if not as uncertain, as death. And they can hardly be said to be levied at a time when the taxpayer is best able to pay them, because he’s dead.
Smith did not see a consumption tax as a panacea: ‘All taxes upon consumable commodities … tend to reduce the quantity of productive labour: He wouldn’t have favored introducing a VAT in the United States. Just the fact that it is in use elsewhere is an argument against it. ‘There is no art which one government sooner learns of another, than that of draining money from the pockets of the people,’ wrote Smith.
Smith was against corporate taxes because ‘The proprietor of stock is properly a citizen of the world and ‘a tax which tended to drive away stock from any particular country, would so far tend to dry up every source of revenue, both to the sovereign and to the society.’ Also, Liechtenstein might end up as a world power. And it could hardly help but have territorial ambitions.
Smith made a sensible argument in favor of property taxes — but only on Republicans with inflated house values in nice neighborhoods: ‘Nothing can be more reasonable than that a fund which owes its existence to the good government of the state, should be taxed peculiarly'. And, since gov­ernment was instituted for the defense of the rich against the poor, he called for progressive taxation: ‘It is not very un­reasonable that the rich should contribute to the public expence, not only in proportion to their revenue, but some­thing more than in that proportion.’ But only if the govern­ment makes the poor knock it off with the graffiti and turn down the rap music.
Smith objected to certain taxes on libertarian grounds:
It would have been impossible to proportion with tolerable exactness the tax upon a shop to the extent of the trade car­ried on in it, without such an inquisition as would have been altogether insupportable in a free country.
We’re very proud of our modern liberty, but that sentence in­dicates we may have dropped a few freedoms while we were stooping to pick up all the new ones.
And Smith had one really brilliant tax idea, a surcharge on ‘the persons who have the administration of government’. He felt that they were ‘generally disposed to reward both themselves and their immediate dependents rather more  than enough’. St Andrews was founded in 1754, so golf junkets with lobbyists were already available. ‘The emoluments of officers, therefore, can in most cases very well bear to be taxed,’ wrote Smith. He predicted this would be ‘always a very popular tax’.
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The case against inheritance tax

In DOF I've argued vigorously against James Meade's (a Nobel prize winner in economics) arguments for an inheritance tax. John Rawls took on Meade's arguments to propose a dramatically enhanced welfare state with strong redistribution.

An article in The New York Times today by Russell Roberts (who is a research fellow at Stanford University’s Hoover Institution and professor of economics at George Mason University) and co-author of Cafe Hayek prompted me to make a comment on the Cafe Hayek blog. 

I encourage you to read Russell's argument but note two other key arguments that I've made in DOF. Let me reproduce the entire section:


Meade advocated a highly aggressive tax on inheritance. We could, in consequence, acquire wealth for ourselves but not be permitted to pass it on. That is simply unacceptable. We live through our children, and while we may not work only for their sake, we have in mind the continuity of our life that our children represent. Our children are us. Rawls wanted the ‘wide dispersal of property’ as part of property-owning democracy. This, he believed, ‘is a necessary condition … if the fair value of the equal liberties is to be maintained.’[1] But that’s not true! Indeed, were such forced dispersal of property to occur, there would be no liberties left because such dispersal is unnatural and coercive. He also wrote, confoundingly, that ‘One naturally imagines that the greater wealth of those better off is to be scaled down until eventually everyone has nearly the same income. But this is a misconception, although it might hold in special circumstances’[2]. This view significantly contradicts his more fundamental statement that ‘[a]ll social values – liberty and opportunity, income and wealth, and the social basis of self-respect – are to be distributed equally’ [emphasis mine].
To thus say that Rawls’s work is replete with confusion would be an understatement, with the implications of his second principle destroying his first principle. And basic puzzles remain. Why would anyone labour their whole life if they were unable to pass on the fruits of this labour to their children? Transfers of assets from one generation to another should be treated seamlessly, ruling out all inheritance taxes (this is also fundamentally a problem on the ground that those families that tend to die at an average age of 50 would be taxed far more heavily than those that die at age 90).
As I noted in my comment at Cafe Hayek, This way families that have differential genes for longevity will be taxed differently. Greater nonsense (in terms of a redistributive theory) cannot be thought of.

[1] Rawls, John, A Theory of Justice (1971), Cambridge, Massachusetts: Belknap Press of Harvard University Press, 1999, p. 245.


[2] Rawls, John, A Theory of Justice (1971), Cambridge, Massachusetts: Belknap Press of Harvard University Press, 1999, p.252.
ADDENDUM 2 April 2011
Another thing occurred to me today in favour of free intergenerational transfer – that it is Pareto optimal. This is clearly an exchange where one party (the inheritor) is made better off without harming anyone (the inheritee, or bequestor, who is dead and can't be harmed). A Pareto improvement should not be touched by the state at any cost.

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An ideal tax system

The question of the design of an ideal tax system has taxed the best of thinkers for centuries.

In my articles in Freedom First in November and December 2009 I had provided a framework for taxes on the basis of first principles of a free society social contract. Now, in an article entitled, "Tax from scratch" The Economist (13 November 2010) reports that Sir James Mirrlees, a Nobel-prize-winning founder of the modern theory of optimal taxation, has produced a report  (here) that details optimal taxation. 

From a quick review of the article (I haven't read the report yet) the report seems to be broadly taking views similar to the ones I have advocated. 

On one thing I do differ from the report: in that I advocate the repeal of corporate tax, noting that it may be necessary to continue with it for some time because of sheer convenience. If a corporation tax is applied, then the principles recommended in this report could be used.

Either way, here's something that adds great value to the classical liberal policy debate.

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A liberal perspective on taxes – Part II

[This write-up was published in Freedom First, December 2009]

Sanjeev Sabhlok

Last month, in the first part of this article I made the comment that internally consistent theories of public finance simply don’t exist. I then went on to (bravely!) propose an internally consistent theory derived from the basic social contact.

The following principles resulted from that analysis, that (a) citizens (and not companies) should pay taxes; (b) paying taxes must be mandatory unless someone is simply unable to pay; (c) taxes should be based on the annual average of the lifetime worth of an individual; and (d) taxes must price-discriminate with a modest level of progression: the marginal rates approximating the overall share of taxes in GDP.

According to the fourth principle, the middle class should pay an income tax at a marginal rate approximately equal to the proportion of overall taxes to GDP; the rich should pay at a rate slightly above this; and those below the poverty line should not pay taxes, receiving a negative income tax as part of the social insurance scheme, instead.

The right level of taxation

A fifth principle suggests itself: the total amount of tax collected should be neither too much nor too little, being just enough to ensure effective delivery of necessary government services. The liberal believes that when governments are restricted to their proper role they provide us with a crucially needed service. In this regard it may be noted that a society comprising a larger share of honest people (like Japan) will need less policing and hence lower taxation. Corrupt societies will need higher levels of taxation.

In any event, the liberal is not smitten by the mindless fascination of some alleged ‘liberals’ for low taxation. It is crucial to have the right size of government with right services and functions. That is the only correct determinant of the right level of taxation. Today, India’s socialist government imposes an extremely low overall tax burden but then it squanders these precious revenues on totally unnecessary activities.

The consequent under-supply of basic public goods like defence, police and justice – including the defence of property rights – has led to significant crime and poverty in India.

The ever-present specter of regressive taxation

Theoretical models of public taxation are extremely difficult to translate into practice. We noted last month how regressive taxation is the norm across the world. The rich pay proportionately less as they get richer. At the same time, the poor (who, we have noted, should not have to pay taxes) fork out heavy consumption and indirect taxes. The most progressive taxes of all are reserved for the salaried upper middle class, which carries the world on its shoulders.

The rich benefit most from any number of exemptions, including a regressive capital gains tax regime. Assume that A and B have the same level of assets today and that they invest equally in, say, land. Now assume that A receives a windfall gain with his land tripling in value while B’s stagnates. Most tax systems will treat A’s windfall gains very lightly, even though A is now considerably richer than B. It is improper for windfall gains to be taxed proportionately less than income from ordinary hard work.

The reality is that even as the rich continue to influence politicians to give them more and more exemptions, they end up suffering from the effects of the consequent regressive taxation regime. While they can own the best Mercedes, they must then hire heavily armed security guards and drive through sludgy, potholed roads. The quality of life is very low in societies that depend on regressive taxation.

Some other principles of taxation

Other principles of taxation include:

  • No taxation without representation (i.e. democratically determined taxes).
  • Inflation is the most regressive form of taxation. The liberal therefore opposes deficit financing except in the rarest circumstances (like war).
  • Taxes must be levied by that tier of government which administers the relevant service (principle of subsidiarity).
  • Since it is citizens who must be taxed, taxation of goods must be avoided, being limited to Pigovian taxes to facilitate the internalizing of negative externalities. Where possible, market-based instruments should be used to control negative externalities.
  • The variable cost of a government service to an individual or industry, such as the cost of processing a license, should be recovered from that individual or industry (cost recovery principle).
  • The government should not own land except for roads, common infrastructure, Parliament, courts, basic defence establishments, and police stations. This will allow land to be put to its most productive use. The government should therefore sell land and use these revenues to keep taxes low.
  • Transfers of assets from one generation to another should be treated seamlessly, thus ruling out inheritance taxes.

Clearly, the liberal is not utopian. He realizes that practical matters related to the ease of collection of taxes will influence the real tax system, even though unavoidable distortions will result. Thing like a mix of indirect and direct taxes; or the use of visible and not discounted future income and wealth; will therefore be unavoidable.

Implications for India

What does this mean for India? A few thoughts are outlined below.

1. India must raise its overall tax level from the current tax share currently of around 16 to 18 per cent of GDP to 25 per cent of GDP (compared with 33-50 per cent of GDP in the West). Note that merely raising taxes without reforming India’s governance model will not improve much. Therefore governance reforms of the sort advocated in my book, Breaking Free of Nehru ( must form the bedrock of reform in public finance.

2. The only defensible way to increase taxes is to broaden the base by requiring all Indian families to lodge annual income and wealth tax returns. Poverty elimination, a vitally necessary part of the liberal agenda, also depends critically on the information received from such returns (see my article in Freedom First, August 2009).

The result would be to increase the base of tax returns in India from 3 crores to around 67 crores.

3. Since abolishing company taxes will be impractical and create many complications, an alternative is to reduce company tax level in India to 25 per cent while requiring dividends paid to Indian investors to be franked through an imputation system: thus defaulting to an income tax system.

4. Apart from eliminating indirect taxes (already touched upon) most excise duties and taxes on products will, in due course, need to be abolished. Pigovian taxes, however, may well be needed on a few products.

5. Given that increases in asset prices continuously transfer significant amounts of wealth to the rich relative to the poor, land and capital gains taxes would need to be increased, aiming at the end of all these reforms for a (broadly) overall flat tax system in India from the current regressive one.

Given space constraints I have been able to present only a sketch of a theory of liberal taxation, but I trust that these two articles of mine will be found broadly reasonable by liberals everywhere.

Freedom Team of India

Once again I’d like to remind that FTI ( continues to look for leaders and seeks your active involvement and support.


Dividend holders pay corporation taxes. Don't forget that! (i.e. my assessment of Warren Buffet is perhaps incorrect)

Comparing Income, Corporate, Capital Gains Tax Rates: 1916-2011 (excellent: from Visualising Economics)

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