Although he lived in the 1700s, Adam Smith is still known and revered today for his work on free-market economics, including taxation. If federal, state, and local governments would follow Smith’s policy prescriptions, more economic wealth would be created. According to many economists today, Smith remains the best tax economist of all time.
Adam Smith is best known for the first theorem of welfare economics–an unfettered market will automatically, as if by an “invisible hand,” allocate a nation’s resources in the most efficient manner possible. Smith’s theories of taxation follow from that principle. Taxes should be levied only to support a limited government and should satisfy four maxims: equity, transparency, convenience, and efficiency. According to Smith, nations that maintain free markets and limited taxes will maximize their wealth.
Smith believed taxes should support four legitimate functions: national defense, justice, universal education, and “good roads and communications.” All four functions are “beneficial to the whole society and may therefore, without any injustice, be defrayed by the general contribution of the whole society.” He added that user fees should help to cover roadway expenses, and that the rich should pay for their children’s education. He thus anticipated both social externalities and user-pay principles. Today, general revenues support many government programs that are not justified by these principles; Smith would surely view them as unwarranted interventions.
Four Tax Maxims
The first of Smith’s tax maxims, equity, reflects his belief that the wealthiest benefit most from government and can most afford to pay. “The rich should contribute to the public expense not only in proportion to their revenue,” Smith believed, “but something more than in that proportion.” Equity, according to Smith, requires progressive taxation. That principle is firmly embedded in the U.S. tax code today.
Smith’s second maxim is that “the tax which each individual is bound to pay ought to be certain and not arbitrary” and “clear and plain”–that is, transparent to everyone. Transparency would help prevent unscrupulous “tax gatherers” from undermining trust in the system. Today’s U.S. tax code falls far short of Smith’s “clear and plain” maxim. International economists view the creation of transparent rules for taxation as one of the most significant economic policy objectives for emerging economies.
The third maxim is convenience. “Every tax,” said Smith, “ought to be levied at the time, or in the manner, in which it is most convenient for the contributor to pay it.” Smith spoke of tax “simplification” in this context and said Britain’s duties on customs could benefit from “the same degree of simplicity, certainty, and precision, as those of [an] excise” on domestic consumption. U.S. taxes hardly meet this test. According to the IRS, taxpayers devoted 3.21 billion hours and $18.8 billion in 2000 complying with the federal income tax.
Smith’s fourth maxim is efficiency: “Every tax” should be devised so as “both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of a state.” This requires keeping administrative costs and economic distortions to a minimum. Economic distortions might “obstruct the industry” of business people and thereby prevent them from giving “employment to great multitudes” of people. The most efficient tax, according to Smith, would leave “the annual produce of the land and labor of society, the real wealth and revenue [of a nation] the same as before.”
The importance of Smith’s insight to the U.S. economy is illustrated by Martin Feldstein of the National Bureau of Economic Research, who estimates that a 10 percent across-the-board reduction in all federal income tax rates would lose about $22 billion per year in federal revenues, while increasing economic efficiency by $40 billion per year.
What Should Be Taxed
Smith applied these maxims to four types of taxes: taxes on the rents from land; the wages of labor; the profits of capital; and taxes that would fall “indifferently” or equiproportionately on all three factors of production.
Smith believed taxes on rents from unimproved land were the most efficient because unimproved land was not augmentable and therefore could be taxed without affecting its supply. However, he was not sure how to isolate the rents from unimproved land from those from improvements resulting from “the attention and good management of land.”
Subsequently, a nineteenth century economist, Henry George, conceived of a single tax on land, essentially sidestepping the difficulty of isolating unimproved land. As the first Nobel Laureate in economics, Paul Samuelson, noted: “Actually, much of the land we use has been augmented by man: it has been drained, filled, and fertilized by investment effort quite like that which builds machines and plants.” (Emphasis in original.)
Smith was most critical of taxes on wages and profits. Both diverted resources from wealth-creating activities, he pointed out, and raised the prices of manufactured goods by more than the amount of the tax. Taxes on the profits of “stock” were destructive of wealth creation because “stock cultivates land; stock cultivates labor,” and a tax on profits diminishes both “the rent of land and the wages of labor.” These considerations remain relevant today as politicians debate the taxation of dividends and capital gains.
Smith believed taxes that fall indifferently on all three factors of production were highly efficient. These include poll or “capitation” (head) taxes and broadly based taxes on consumption. However, Smith rejected poll taxes as extremely regressive and excluded basic necessities such as wooden shoes and vegetables from taxable consumption. He had mixed emotions over taxing beer. Numerous “exemptions” reduce the efficiency of consumption taxes today.
Smith opposed targeted taxes on specific industries and regions because they “always alter, more or less, the natural direction of national industry, and turn it into a channel always different from, and generally less advantageous than that in which it would have run of its own accord.” He noted that Great Britain’s uniform system of taxation, “this freedom of interior commerce,” was a “principal cause” of its “prosperity.” America’s founders, many of whom read The Wealth of Nations, inserted an Interstate Commerce Clause into the Constitution.
Smith opposed Britain’s customs duties because they distorted trade, and because they were so high they reduced consumption and increased smuggling so much that a lower tax would generate greater revenues. Shades of Arthur Laffer!
Most of Smith’s theories of taxation are valid and relevant to the debates over tax reform today. Limited taxes that are equitable, transparent, convenient, and efficient, combined with an “unfettered market,” are still essential to maximizing the wealth of a nation.
Tom Walton is an economist with General Motors in Detroit and a member of the Board of Directors of The Heartland Institute.