BOOK III, CHAPTER II
THE GENERAL FEATURES OF TAXATION
§ 1. The increasing importance of taxation as a mode of supplying the public wants is a conspicuous feature in financial development. It is partly attributable to the decline of the earlier forms of revenue, but far more to the great and continuous growth of expenditure. The modern State is dependent on taxation to an extent unknown in mediæval times. Hence all questions connected with this department of finance have an enhanced interest. Errors on the subject, or mistakes on the part of practical financiers, tend to become more and more serious and the need of a careful study of the general features of the tax system is greater. Without a true appreciation of the conditions under which it works, it is hopeless to expect the adoption of a wise policy, or determination in applying it. Practical sagacity has its part—and no small one—in successful financial management, but it is all the more effective when enlightened by the study of principles. The complications of modern financial systems make it advisable to note their chief characteristics before discussing the comparative merits of the rules proposed for their regulation. The phenomena are not so simple as to admit of regulation by a single mechanical rule, and the real bearing of the different propositions will be best understood after some acquaintance with the subject-matter to which they are applied, and the difficulties that surround them. The interaction of state and national economy brought about by taxation produces further complications that will not allow of hasty treatment. We shall therefore begin by a study of some of the general features of the tax-system, a knowledge of which is essential for forming a correct judgment respecting its regulation.
§ 2. Looked at in a broad general way, the first circumstance that strikes the observer is the fact that taxation means the subtraction of so much wealth from individual enjoyment or use. The definition given in the last chapter seeks to express this fact by pointing out that taxes are contributed by persons from their wealth for the public service. State expenditure is devoted to the supply of certain wants of the community or nation by the action of the public powers. These, like all other agencies, cannot be obtained without cost, partly met by the economic or quasi-private revenue, but leaving a balance to be supplied by taxation. It thus appears that there is an element of truth in the description of taxation as 'the expenses of production of the State'; the phrase, however, suggests too close an analogy with industrial enterprises, in which the expenses are repaid out of the product. In respect to public services, the benefits will in normal cases largely exceed the cost, but the method of calculation is not so easily applied, nor is the object in view the attainment of profit.
The proposition that taxation is the form of cost or expense proves that it is so far an evil in the sense that every sacrifice is such. It may be necessary or advisable, but could the object be otherwise accomplished it would be still better. Any saving in the expense of working the State enables a larger amount to be left in the possession of the tax-payers, and to that extent improves their economical position. The former statement of this very plain fact might appear superfluous were it not for the existence of strong popular prejudices in favour of the expenditure of funds derived from taxation. 'Government expenditure gives employment and benefits the labourers' is the commonest form in which this belief is asserted. Without entering into the question how far such expenditure does really reach the labourers, it is sufficient to reply that the persons from whom the funds have been taken by the tax-collector would certainly have made use of them, either in the employment of labour, or the purchase of commodities. The belief that taxation returns in 'a fertilising shower' was rightly regarded by Bastiat as one of the errors arising from defective observation.*30 Hardly worthy of refutation as a theoretic doctrine, its evil effect, particularly in democratic societies, in producing extravagant expenditure is not to be overlooked.
The idea that 'taxation is the best form of investment' is placed by Bastiat in the same category as the gross fallacy just refuted, but it admits of a more favourable interpretation. If it be said that the taxation required for the national defence, the maintenance of justice, and the necessary functions of the State, has been invested in the best manner and yields a good return, the assertion is substantially true, though perhaps expressed in a misleading way, as the State cannot be regarded as a mere industrial concern. Further, as Leroy-Beaulieu points out, the proceeds of taxation, if employed in public works, may yield a satisfactory profit, and thus be, in the literal sense, 'a good investment.' The expediency of such investment belongs rather to the subject of expenditure than to that of taxation, but we may remark that, if public works are likely to be profitable, it seems better on the whole to raise the requisite funds by a loan, to be repaid through the agency of a sinking fund. To use taxation for this purpose is almost equivalent to a 'forced loan.'*31
§ 3. The consideration of taxation as reproductive in the way of investment suggests the further question of the possibility of its productiveness through reaction on the national economy. If the use of the funds raised by taxation can prove beneficial, may not the effect of taxation itself on production be sometimes good? This view is expressed in the maxim discussed by Hume, 'that every new tax creates a new ability in the subject to bear it, and that each increase of public burdens increases proportionably the industry of the people,' which, he thinks, 'must be owned, when kept within certain bounds, to have some foundation in reason and experience.'*32
Natural disadvantages sometimes stimulate industry, why then should not artificial ones have the same effect? The most remarkable economic progress has been made in countries where man has had to exert himself in consequence of the parsimony of nature, not in those that possessed the richest and most fertile lands. A judicious use of the engine of taxation would, it might be thought, have a similar effect on the disposition of the people. Such was the opinion of McCulloch, who maintained that the heavy taxation of England, during the French wars (1793-1815), was one of the causes of the growth of wealth at that time, since it stimulated industry and the spirit of enterprise and invention.*33
The doctrine in this rather extreme form admits of an easy refutation; for if taxes create a new ability on the part of the payers there can be no determinable limit to their useful employment. A wise government would increase taxation indefinitely, and thereby augment the national possessions. The process of creating fresh wealth by simply taking it from the producers is so evidently impossible that its advocates hesitate to carry their view to its logical outcome. There is in truth a two-fold fallacy in the argument. In the first place, natural obstacles do not, in general, stimulate to exertion; economic development is not greatest among the Eskimos, or the Fuegians, as it ought to be on this hypothesis. Some natural difficulties urge man to action, but others reduce him to torpor, and check the first steps towards civilisation. The influence of natural disadvantages in promoting the growth of wealth is rather by their indirect effect on the physical and mental qualities of those subject to them, not by the economic loss that they occasion. Secondly, the analogy between natural and artificial obstacles is defective. It does not follow, because men work more strenuously (and this is doubtful) to till a barren soil, that therefore they will exert themselves the harder the more they suffer from the incursions of marauders. The greatest promotive of industry is security, and protection from arbitrary or oppressive taxation is but one form of that 'protection against the Government' on which Mill justly insists as more important even than 'protection by the Government.'*34
Later on, however, Mill appears to adopt a milder form of McCulloch's view. When examining the effect of a tax on profits, he declares that 'It may operate in different ways. The curtailment of profit, and the consequent increased difficulty in making a fortune, or obtaining a subsistence by the employment of capital, may act as a stimulus to inventions, and to the use of them when made.... Profits may rise ... sufficiently to make up for all that is taken from them by the tax. In that case the tax will have been realised without loss to any one.'*35 Such a result, though possible, is extremely unlikely, as the additional production in consequence of the tax would itself be subject to taxation. A low rate of profit may lead to the introduction of economising expedients, but the expectation of a high rate is far more effective in increasing production. There is just as much, and just as little, truth in the belief that low profits encourage industry, as in the similar beliefs that low wages make the workman and high rents make the farmer industrious.*36 Some special examples have been brought forward in support of the position that certain forms of taxation stimulate invention. McCulloch cites that of the Scotch distillers, who, under the influence of a spirit duty, assessed according to the contents of the vessels, so improved their processes by economy of the time spent in distilling, that instead of taking a week, they in a few years required only three minutes, and thereby were able to bear a duty nearly forty times as great as at first. Somewhat similar improvements have been introduced into the Continental beet-root sugar industry in consequence of the method of imposition, which assumes a certain yield and charges duty only on that amount, leaving any excess free.*37 What is really striking in these cases is the fact that invention has been stimulated, not by the duty, but by the possibility of escaping it: the imperfect form of assessment has encouraged efforts in this direction that would cease if the true return were brought under taxation. They do not show in the slightest that the progress of invention is greater in a taxed industry than in one free from taxation. All antecedent probability, and all actual experience, go to prove the opposite.*38 One great impediment to the use of new processes is the surveillance that taxation renders necessary.
The result of the preceding discussion is, briefly, that any compensating effect of taxation in increasing production is extremely doubtful, and is at best so small, and occurs in so few cases, as not to form an element worthy of entering into the rational calculations of the financier. The raising of compulsory revenue means so much loss to the payers and to the community, for which the only return obtained is the benefit resulting from the efficient execution of state functions. Any doctrine that removes attention from this cardinal fact is erroneous in principle, and may lead to serious practical evils.
§ 4. Nor does taxation only mean the withdrawal of the amount required by the public powers from the disposable funds of the subjects of taxation. It may, and often does, take much more. In all countries the cost of collection is no inconsiderable item, which must be added to the actual amounts needed by the state departments unless it be regarded as an additional state function. In either view it increases the burden to the payers. Consequently, one of the most generally recognised maxims of finance is that which prescribes that 'Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the State.'*39 This rule, declared by Wagner*40 to be simply the application of the general principle of economy to public finance, has two distinct applications: (1) as regards the State itself, the aim of securing the best return in amount of taxation for the expense incurred in collection is very plain, but even when this is realised there is (2) the still more important object of not inflicting indirect loss on the subjects, either by the obstruction of industry that taxation causes, or by the inconvenience that the regulations incident to the system of collection may produce. Some forms of taxation are much more oppressive in these respects than others, and one of the principal tasks of financial practice is to discover the least burdensome modes.
The public economy depends ultimately on the national economy; anything that reduces the economic power of the individual citizens is an injury to the State. A system of taxation that diminishes the revenue of the subjects without a corresponding return to the public treasury is certain before long to show its effect in reduced receipts from taxation.
A comparison of English taxation as it existed in 1820 with that now in force proves how much may be gained by a determination to conform to the rule of 'economy.'*41 But even in the best existing systems of finance there is a large amount of waste, some of it unavoidable. The raising of such a sum as £120,000,000 in the course of a year cannot be accomplished without much interference with industry and trade and a great deal of annoyance to individuals. From a purely material point of view this canon of 'economy' is probably the most important in fiscal science, and no efforts should be spared to secure the closest observance of it that existing conditions permit.
§ 5. The supply of state wants by taxation is then, it is plain, a charge on the collective resources of the community. Finance is no exception to the general rule that it is impossible to obtain something out of nothing. Prudent management may make the available resources go farther than they otherwise would. The financier, like the mechanician, proves his ability by the direction, not by the creation, of force, and especially by reducing to a minimum the loss through friction. But having decided that taxation is a charge on the national resources, there is room for further inquiry as to the precise fund on which it falls. We have already mentioned Adam Smith's opinion that it must be derived from the shares of revenue. Ricardo declares that 'Taxes are always ultimately paid either from the capital or from the revenue of the country,'*42 and expands his statement by pointing out that the proceeds of a tax must curtail consumption, increase production, or reduce capital, i.e. 'impair the fund allotted to productive consumption.' From this he concludes that taxation should be imposed on revenue rather than on capital, since the latter form of tax tends to check future production. Some writers have even raised this into a maxim of finance.*43 The danger of hindering the growth of capital is apparent, though as capital is derived from revenue it is not easy to avoid taxing it to some extent. 'To provide that taxation shall fall entirely on income and not at all on capital is,' says Mill, 'beyond the power of any system of fiscal arrangements.'*44 In actual economic life the line between capital and non-capital is not so fixed and rigid as the text-book definitions would make us believe.*45 Any tax is certain to take some wealth that would otherwise have been devoted to the aid of production, and also some that, if left to the taxpayers, would have been consumed unproductively. How much will come from each source is not easily determinable.
The distinction between capital and revenue is, besides, not quite the same when considered from the national rather than the individual point of view. Much individual capital is not national capital, and this is likewise true of revenue; but for the financier it is national capital and revenue that need attention. Any pressure on the most important auxiliary of production is as far as possible to be avoided; but when capital is rapidly increasing, a tax that appears to trench on individual capital, as e.g. the English Death Duties, is not open to the objection of reducing national capital in the same degree as it would be in a poor and unprogressive country. Taxation is drawn from the total stock of wealth, including at any given time both capital and revenue. The real aim should be to so direct it as to interfere to the smallest extent with the action of the forces that promote accumulation. Heavy taxation will always be injurious in this respect. If imposed on revenue it reduces the fund from which capital comes, and may even lead to direct encroachments on individual capital: if on capital it leaves revenue free to partially fill up the gap that it has made. There is no impassable barrier between the two categories of wealth; any action on one will, in all probability, extend to the other.*46
In addition to the productive capital and annual new production, every civilised society possesses a large mass of wealth in process of use, 'stock reserved for immediate consumption' as Adam Smith calls it, 'consumers' capital' in Sidgwick's phrase. There is in this 'stock' a further source on which taxation may fall without injuriously affecting the productive powers of the community. In fact, we can fairly say that no less comprehensive term will suffice to describe the source of taxation than that already employed, viz. 'the collective wealth' of the country. But in actual societies in their normal condition taxation is derived from the national revenue, some of which would have been transformed into capital. Nothing but a national crisis would justify taxation so heavy as to absorb the free income of the society and reduce the sum of its accumulated wealth.
§ 6. A celebrated doctrine has carried still further this limitation, and maintained that all taxation should be levied on the net, as opposed to the gross, income. Net income is asserted to be the only disposable fund for the purpose. Gross income includes the necessary expenses of maintaining the citizens and replacing the national capital. To touch on that part of the gross receipts would be a blow to the industrial organisation, inasmuch as it is an essential requisite for the society being continued in its full efficiency as an economic machine. A tax that takes away a part of the labourer's necessary subsistence, or lowers profits below the minimum for which men will consent to take the risk of investment, is indefensible, and in the long run defeats its own object.
The earliest appearance of this doctrine is with the Physiocrats. Their theory of the 'produit net' has its chief application in respect of taxation. The fifth of Quesnay's maxims lays down 'that taxation should not be destructive or disproportioned to the sum of the national revenue; that its increase should follow the increase of revenue; that it should be imposed immediately on the net product of land.' According to Du Pont de Nemours, 'the portion of the returns called the net product is the sole contributory to taxation, the only one that nature has prepared to meet it. It is of the essence of taxation to be a part of the net product of cultivation.' Mercier de la Rivière is, if possible, clearer. 'Taxation is nothing but a part of a net product, and can be levied only on a net product.'*47 The conception of the net product as consisting of nothing but the rent of land appears absurd, but the way in which Quesnay and his followers reached that startling result is not hard to follow. In their opinion the labourer requires a definite amount of commodities for his subsistence; more than that he will not receive, and so much he must get under penalty of starvation. This 'subsistence theory' of wages was fully accepted by the Physiocrats,'*48 and fairly accorded with fact in the France of the Ancien Régime. Precisely analogous is the position of the capitalist. The rate of interest is just sufficient to keep up the existing supply of capital. The interest on capital advanced is, Turgot tells us, 'the price and the condition of that advance, without which the undertaking could not continue. If that return is diminished the capitalist will withdraw his money, and the undertaking will cease. That return ought then to be sacred and enjoy an entire immunity.'*49
When wages and profits are removed by the nature of things from the tax-collector's power, it goes without saying that rent is the only remaining source on which he can draw, and we are compelled, their premises being given, to accept the Physiocratic conclusion. Adam Smith, however, declined to follow this seemingly rigorous deduction. He holds that both wages and profits may contribute to taxation, though the amount to be obtained from the former must be very small. Ricardo takes the same view. While asserting formally that it is only from profits and rent 'that any deduction can be made for taxes,' wages 'if moderate constituting always the necessary expenses of production,' he qualifies his statement by the admission that labourers may receive more than their necessary expenses, in which case the surplus is a part of 'net produce.'*50 Finally, J. S. Mill emphasises the share of the labourers in 'net produce,' and seems to desire to amend Ricardo's doctrine on this point.*51
§ 7. The doctrine of net income as the sole source of taxation, whose history we have just traced, has met with strenuous opposition in Germany. For the last thirty years the fact that taxation is a duty incumbent on the citizen and to be paid by him, not by the pure abstraction called 'net income,' has been loudly proclaimed. Hermann's theory of 'use capital' (Nutz-capital) has been employed to show that there is an enjoyment revenue to be added to the economic revenue derived from production in the strict sense. 'It is,' says Cohn, 'undoubtedly income that the owner of a house enjoys from his residence in it, the owner of a park from his enjoyment of the park, that a person enjoys in his own hunting-ground, in his own picture gallery. It is income in the specific form of enjoyment of property.'*52 Such an extension would give a larger fund on which to draw, though it seems preferable to regard these forms of wealth, in the way adopted in a preceding section of the present chapter, as property or capital, and so far liable in exceptional cases to taxation. Of greater force is the argument that the cost of maintaining the State is itself a part of the necessary expenses of the society. The protection of person and property, the duty of the public powers even in the opinion of the extremest individualists, is almost as indispensable as feeding or clothing. So far then from taxation being dependent on the surplus produce of the community, it may with justice be looked on as one of the first charges on the gross production, coming next to that minimum of food and covering that is needed for the preservation of life.
The apparent contradiction between two such plausible opinions can, we believe, be escaped by taking a broader view of the subject than the disputants on either side have done. Necessary expenses are in no case a fixed amount. Each standard demands a certain minimum outlay, but the standard can be varied. The subsistence standard of the English labourer has always been higher than that of the Hindu, and what is true of labour is equally true of the other factors of production. The amount of capital can be reduced to suit a less intensive method of production, and the smaller the quantity needed, the less, cæteris paribus, will be the rate of interest. And so is it also with state wants. Their amount and cost can and have to be adjusted to the general position of the society. The difficulty of laying down any definite rule as to the proportion of national income, gross or net, that ought to be devoted to the public service has been shown at an earlier stage of our inquiry.*53 Here it will suffice to distinguish between that part of taxation that conduces directly or indirectly to the production of wealth and that which produces non-economic advantages. The former is beyond dispute a part of the cost of production; without it the amount of wealth would be smaller, and the payment of this part cannot be said to come from the net income, or surplus after necessary expenses are met. The latter, like all other forms of enjoyment, can be dispensed with, and yet leave the amount of production as great as before. It may, therefore, be said to come out of the net produce in the wider sense given to the term by Mill. This separation is, however, very hard to carry out. All forms of public expenditure have some effect in promoting industry,*54 and some retrenchment might be made in all without economical loss to the society. Still the principle of the separation is intelligible, and within limits can be usefully employed.*55
§ 8. Inquiries respecting the derivation of the tax revenue from gross or net income, or from the sum total of the national wealth, may appear at first a piece of unnecessary subtlety. They have, however, important practical bearings. Until the normal source of taxation has been determined, it is impossible to estimate the pressure that it places on a community. The taxable capacity of India or Ireland would be very different according as gross or net revenue is taken as the measure; and in a comparison between Great Britain and the United States, the test of income would probably give the first place to the latter, while that of property would assign it to the former.*56 In another important question of finance the problem of the true source of taxation becomes of moment. The justice of any particular system of taxation cannot be estimated without a knowledge of the fund from which the tax revenue is derived. According as taxation has its source in gross or in net income our view of the equity of existing systems must vary.
The principles just stated find an important application in the case of the financial position of Ireland. It has been argued with apparent plausibility that the cost of subsistence of the Irish population should be deducted from its gross income in order to ascertain the fund disposable for taxation. But this at once raises the difficult question of calculating the cost of subsistence, and also suggests that the doctrine of section 7 as to the variableness of necessary expenses should be taken into account. Sir R. Giffen has assumed that the amount of £12 per head should be taken as the minimum standard, and thus departs in two respects from the taxation of true net income, for (a) the assigned amount is too high for a very poor population, and (b) far too low as an allowance for expenditure necessary for efficiency in the higher grades of producers. In comparing the taxable capacity of two countries it is the amount in each really disposable for the tax-collector that should be considered. In no case can this exceed a part of even so-called 'net income.' The poorest population must have something above bare subsistence, since there will always be persons much wealthier than the mass of the people. This question is, moreover, one, not of equity but of fact, to be ascertained by appropriate evidence, which is, in truth, very difficult to procure.*57
Notes for this chapter
Bastiat, Œuvres, v. 344 sq.; cp. Leroy-Beaulieu, i. 118.
Leroy-Beaulieu, i. 125-6. See above. Bk. i. ch. 8, §§ 2, 3. Also Bk. v. ch. 5, for a discussion of the expediency of public borrowing for this object.
Essays (ed. Green and Grose), i. 356. Prof. Seligman (Essays, 86 n.) is mistaken in supposing that the doctrine is here 'ascribed' to Hume, as any reader of the text can see.
Taxation and Funding, 7 sq.
Principles, Bk. i. ch. 7, § 6.
Ib. Bk. v. ch. 3, § 3.
For a good refutation of the idea that low wages make workmen active, see Wealth of Nations, 34. Arthur Young approved of high rents as promoting industry, Northern Tour, ii. 80-83; and Sir J. Caird deprecated under-letting, but wisely remarked that the opposite error of overletting is much more hurtful English Agriculture, 477.
McCulloch, 151-2; Leroy-Beaulieu, i. 258-260.
For further discussion on this point, see ch. 4 of the present Book, also Bk. iv. chs. 6, 7.
Wealth of Nations, 348. The fourth of Adam Smith's 'classical' rules See Bk. iii. ch. 7.
Wagner, ii. 467. In Jevons's phrase, 'The maximisation of utility.'
See on this Dowell, ii. 249, 261, who quotes Sydney Smith's humorous account.
Works (ed. McCulloch), 87.
'Tout impôt doit porter sur le revenu, et non sur le capital' is the first of Sismondi's maxims. Nouveaux Principes, Liv. vi. ch. 2.
Bk. v. ch. 2, § 7.
See Marshall, Principles, Bk. ii. ch. 4, for a discussion of the diverse application of the term 'capital.' 'There is, and from the nature of the case there must be, something artificial in every broad distinction between capital in general and other forms of wealth.' Ib. 'Preface' to 3rd. ed., vi.
See Bk. v. ch. 5, § 9, for further treatment of this point.
Quesnay in Daire, Physiocrates, 83; Du Pont, ib. 351; Mercier de la Rivière, ib. 474. See also Quesnay's Œuvres (ed. Oncken), 332.
The often-quoted passage of Turgot, 'En tout genre de travail il doit arriver et il arrive en effet que le salaire de l'ouvrier se borne à ce qui lui est nécessaire pour lui procurer sa subsistance' (i. 10), shows this.
Turgot, i. 63.
Principles, Bk. i, ch. 11, § 1.
Bk. i. ch. 8, § 2.
Cp. Bk. i. ch. 6, § 1, for the relation of state expenditure to industry and commerce.
On the whole question cp. Wagner, ii. 315 sq.; Cohn, §§ 236 sq.; Roscher, § 35: Held, Einkommensteuer, 66 sq. For Hermann's theory of income see Staatswirthschaftliche Untersuchungen (2nd ed.), 582-598. Professor Marshall has developed Hermann's view, Principles of Economics, i. 139 sq.
Giffen, Growth of Capital, 124-139.
See on this point the Report and Minutes of Evidence of the Royal Commission on 'Irish Financial Relations' [C. 7720 and 8262]. Special reference may be made to the memorandum of Sir R. Giffen, C. 7720, ii. p. 166, and the note by Prof. Sidgwick, ib. 182-3.
Book III, Chapter III
End of Notes
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