Adam Smith on Public Policy: Four Maxims of Taxation
Adam Smith said taxation should be imposed in proportion to the benefits a taxpayer receives from the state and should be predictable, convenient, and efficient.
Adam Smith devoted a significant portion of the Wealth of Nations to the issue of taxation. Who should be taxed, how much, to what purpose, and in what manner? The first couple pages of the second part of book V set up Smith’s principles, or maxims, of taxation. The rest of the section examines historical tax policies across Europe and how they frequently failed to meet these maxims.
Smith argued that taxes should be proportional to how much a person benefits from living in society. There should be proportionality across levels of income and sources of income such as rent, profit, and wages. At one point Smith does mention how having some taxes fall disproportionately on the wealthy, such as taxes on luxuries, is not so bad. But he stresses proportionality as the general principle: “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”
Smith uses the analogy of a joint venture to compare taxation to the “expence of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate.” Taxpayers are like shareholders. Larger shareholders in a venture contribute more while smaller shareholders contribute less. This sounds similar to Nozick’s theory of a private state or other libertarians’ proposals to make municipalities more like hotels. As I pointed out in my initial discussion of Smith and libertarianism, however, Smith concedes that governments should do many things minimalists like Nozick or anarchists like Rothbard would reject.
Smith’s second maxim is that the “tax which each individual is bound to pay ought to be certain, and not arbitrary. 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.” Having known and predictable taxes allows people to calculate and make better plans. Clear rules of the game encourage more investment, productivity, and innovation. The theme of predictability is discussed at great length by Hayek in a variety of places, but most clearly in his discussion of the rule of law in the Constitution of Liberty.
Without clear predictable tax laws, the risk of abuse by tax collectors increases rapidly. The labyrinthian tax code and recent abuses by the IRS show the truth and prescience of Smith’s maxims. With complex and arbitrary tax laws: “every person subject to the tax is put more or less in the power of the tax‐gatherer, who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some present or perquisite to himself.”
Instead, Smith’s third maxim is that taxes ought to be easy and convenient for the taxpayer. That means “every tax ought to be levied at the time, or in the manner in which it is most likely convenient for the contributor to pay it.” In this respect, at least, I think Smith would applaud automatic withholding—though he might reject it for how it allows governments to tax people more than they realize.
Smith’s fourth maxim of good tax policy is limiting deadweight loss: “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 publick treasury of the state.” He uses “take out” to refer to money taken from people and “keep out” to refer to unrealized income due to tax burdens, distortions, and disincentives. He describes four ways taxes can create deadweight losses. First, there is the cost of hiring tax collectors to collect and process taxes. The more a country spends paying people to gather taxes, the less additional revenue it will have to spend in other areas. Second, taxes can discourage industry. High taxes or taxes on industries with highly elastic demand will result in much less production and maybe even less tax revenue over time. Third, ruinous tax rates will encourage tax evasion and black market activity. Fourth, paying taxes is simply annoying and burdensome. This fourth category may be the biggest deadweight loss in the U. S. today as tens of thousands of people are employed as tax accountants and tax lawyers. Furthermore, millions of hours are spent filing taxes by individual taxpayers every year. These costs are clearly deadweight costs and reduce economic efficiency.
Smith’s maxims of good taxation are not as novel today as they were when he first wrote them. Most economists agree that simpler and fairer taxes will promote economic growth. But given the complexity, obscurity, and arbitrariness of our current tax code, it never hurts to remind people that we have known about good principles of taxation for hundreds of years. It was all right there in Adam Smith.