Front Page Titles (by Subject) PART TWO: The Choice Among Fiscal Institutions - The Collected Works of James M. Buchanan, Vol. 4. Public Finance in Democratic Process: Fiscal Institutions and Individual Choice
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PART TWO: The Choice Among Fiscal Institutions - James M. Buchanan, The Collected Works of James M. Buchanan, Vol. 4. Public Finance in Democratic Process: Fiscal Institutions and Individual Choice 
The Collected Works of James M. Buchanan, Vol. 4. Public Finance in Democratic Process: Fiscal Institutions and Individual Choice Foreword by Geoffrey Brennan (Indianapolis: Liberty Fund, 1999).
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The Choice Among Fiscal Institutions
The economist does not know, and should not know, and should not be concerned as to whether his theories, his models, his instruments or research, serve or should serve a few, many, one, or none at all. If they are not correct, others will expose the errors, modify them, perfect them.
—Luigi Einaudi, in his Inaugural Lecture for the academic year 1949-50 at Torino. Cited by Aldo Scotto in “Luigi Einaudi,” Economia Internazionale, XV (February, 1962), 35.
The Levels of Fiscal Choice
In Part II an attempt will be made to examine the individual’;s choice among fiscal institutions, as institutions. This level or stage of individual choice behavior, which may be called “constitutional,” differs from that discussed in Part I as well as from that which has concerned traditional public finance theorists. The three separate levels or stages of individual fiscal choice should be explicitly distinguished.
Individual Choice Behavior in Traditional Public Finance Theory—Individual Responses in Market Choice to Imposed Fiscal Patterns. In the orthodox approach, the individual does not make either public-goods choices, as considered in Part I, or institutional choices, to be considered in Part II. Or, to state the same thing somewhat differently, these choices are not normally investigated. The fiscal and the institutional choices for the collectivity of individuals are assumed to be made externally to the individual’;s own potential choice system. He is presumed able to choose only in his private market behavior as he reacts to the various tax-expenditure mixes under institutional structures that are externally imposed upon him. The behavior of the individual, as choice-maker, remains the center of analysis, but it is the individual’;s private choice among market alternatives, as the latter are modified by the imposed fiscal structure. A typical problem posed in traditional public finance theory is: Given the institution of the personal income tax for raising government revenues, and given the level of rates that are imposed, how will the individual’;s choice in allocating his time between work and leisure be made, and how will this choice be influenced by a change in the level of tax rates or by a switch to an alternative institution?
Individual Choice Behavior Under Given Fiscal Institutions—Individual Responses in Fiscal-Collective Choice Under Imposed Fiscal Institutions. In the discussion of Part I, we moved one stage or level beyond the traditional emphasis on market-choice reactions of individuals. In a democratic political order, individuals also choose the amount of public goods and services that the community will purchase and supply to its citizens. The individual, along with his fellows, makes public-goods choices as well as private-goods choices. The institutions through which these choices are organized may influence his behavior. An attempt was made to analyze this choice behavior and to predict the direction of effect exerted by a few of the commonly observed institutions of modern fiscal systems in democratic countries. For purposes of this analysis, the institutions themselves were assumed to have been selected externally to the individual’;s own choices. A typical problem under the approach of Part I is: Given that revenues are to be raised through a progressive tax on personal incomes, how will this fiscal institution influence the individual’;s choice in allocating resources between public goods and private goods?
Individual Choice Behavior in Selecting Among Fiscal Institutions. Under a democratic political order, individuals do more than choose in the marketplace and participate in collective choice under given institutions. Ultimately, at some “constitutional” stage of decision, they must also select or choose the structural framework for choice itself; they must choose the institutions under which both day-to-day market choices and ordinary political choices are implemented. It is extremely important that the separate levels or stages of individual choice be considered separately. We may, as in traditional public finance or as in Part I, examine the effects that the institution of the personal income tax exerts on an individual’;s behavior in either the marketplace or the voting booth. But at some “earlier” stage of decision, we may also examine his behavior in selecting the particular institution of the income tax over other revenue-raising alternatives. At this level of analysis, we try to compare the personal income tax with other institutions, say, the corporation income tax. For the approach of Part II, a typical problem is: How will the reference individual choose among the several possible alternative tax institutions through which he will exercise ordinary fiscal choices as to the amount of resources devoted to public goods and services?
The Interdependence of Choice
There are three levels of fiscal choice. The individual asks himself: First, how will I choose to pay for the collective goods and services that are to be provided; secondly, how much will I choose for the collectivity to provide; and, thirdly, once some group choice is made, how will I react to the changed market conditions that confront me? While it is essential that these three levels of choice be separated analytically, it should also be clear that the three are inherently interdependent. As in most situations of choice, “idealized” behavior requires, or seems to require, simultaneous adjustment of all the choice variables. Specifically, the individual’;s choice of a tax institution will depend on his choice for a public-goods quantity and mix and upon his choice of a private market reaction to collective fiscal outcomes. Any satisfactory theory of normative behavior on the part of the individual must work out the process through which these three sets of choices are simultaneously made.1
The Cost of Decision-Making
Such idealization ignores, however, one element of the decision process that can be of major importance. This is the costs of making decisions themselves. In a world where individual decisions can be made in complete isolation one from the other, this cost element may be neglected for most purposes. But in a setting where individuals must, somehow, participate in attaining some sort of consensus on collective outcomes that must, once settled, apply to all, these costs may become large indeed. Once this is recognized, even idealized individual choice need not require simultaneous determination of all values for the choice variables. In this context, it may become rational for the individual to consider his choice among rules or institutions independently from his own particular choices to be exercised within the operation of these institutions or rules. In other words, it may become rational for the individual to discuss his choice among alternative institutions under which subsequent choices will be made independently from these later choices or his predicted reactions to them.
This separation of the “constitutional” decision from what may be called the “operational” decision of the individual is important, and it is essential to the logic of Part II. It may be illustrated with reference to fiscal institutions and fiscal choice, the particular emphasis here, although it is more generally applicable. Consider the decision or choice calculus of a single reference person in a political community. He tries, we shall assume, to articulate his preferences with respect to the share of economic resources to be devoted to public rather than to private uses. He must decide on the institution of payment for public goods, the tax structure. He must decide on the quantity and mix of public goods to be supplied under this structure, the size and composition of the budget. And, finally, he must decide how he will react to the modified conditions of choice that he will confront in the marketplace as a result of the fiscal setting.
These decisions are interdependent, as noted, but when he recognizes the costs of negotiating agreements with his fellows on the institutions of payment for each and every budget, the individual may prefer, on efficiency grounds, to separate the institutional decision from the standard budgetary decision. In other words, he may agree that the group should decide, “constitutionally,” on the institutions under which fiscal (budgetary or public-goods) choices shall be made, quite independently of these choices themselves. He may say, to himself and others: “I simply do not know what public goods and services I shall want and in what quantities over a whole range of future budgetary choices, but can we not discuss the institutions under which we shall pay for whatever public goods and services we decide to supply to ourselves, and in whatever quantities we decide to supply them? In specific terms, can we not decide, constitutionally as it were, whether or not we shall raise public revenues through an income tax or through a sales tax?”
Such a treatment of the institutional structure in some independent “constitutional” process will reduce the costs of arriving at ordinary budgetary decisions on the quantity of public goods and services to be supplied. The imposition of such institutional constraints amounts to setting the rules of the “fiscal choice game,” whereas without such constraints the game is really without rules at all. This conclusion holds regardless of the ultimate rules for reaching collective decisions, these also being assumed to have been determined constitutionally. Whether political decisions are reached on the basis of Wicksellian unanimity, simple majority voting, or any one of the many other variants and combinations that are possible, the independent selection of fiscal institutions reduces decision-making costs. It does so because it removes from the direct budgetary calculus a whole set of bargaining counters that would otherwise be brought into play.
It should be emphasized that the incorporation of decision-making costs in the model does not necessarily imply that rational behavior requires a separation of the institutional and operational levels of choice. There seems no way of demonstrating, a priori, that either this procedure or that of simultaneous choice of all relevant variables is relatively more “efficient” in any particular circumstances. Under certain conditions, it is surely rational for the individual, and for all individuals, to choose the fiscal institutions for the supply of public goods along with this supply itself. Under certain other conditions, efficient behavior surely suggests the opposite. If this latter set of conditions are accepted as possible, then we are justified in Part II in examining the calculus through which the individual selects a fiscal institution independently of the particular characteristics of the public-goods choices that may be confronted.
Institutions as Rules
How will a member of a political community go about making a personal choice among alternative fiscal institutions? The precise setting of the problem is important, and this can perhaps best be described in terms of an explicit model.
Assume the existence of a political community in which all day-to-day decisions on the supply of public goods are to be made by simple majority voting in some town-meeting fashion. Each individual knows, in advance, that any and all proposals for fiscal action will be decided in this manner. Any citizen may present to the group motions concerning the level of public outlay on particular items, or on the levels of tax rates producing revenues for those items. Further, we assume that a given individual has no way of predicting just what proposals are likely to be presented to the group for choices, and even if he should be able to make some rough predictions in this respect, he has no way of predicting just where his own preferences would fall with regard to specific motions. In other words, the individual cannot predict whether, say next year or ten years hence, a motion will be made to spend X dollars draining the boondocks. And, even if such a motion is to be made, the individual cannot now tell whether or not he would join in support or in opposition since he knows neither his own tastes in future periods nor his own economic position.
Suppose, now, that a “constitutional” session of the group is convened, and the group is asked to decide, collectively, on an institution of taxation. That is to say, some such institution is to be selected which will, if and when approved, be used to finance whatever expenditures that may be proposed and approved in future periods. To return to the example, the individual’;s future behavior with respect to support or opposition to draining the boondocks would depend, in part, on the way such spending is to be financed. Now, however, he is asked to choose a way of financing all possible spending proposals that may be approved, independently of any knowledge of the pattern of approved motions that may emerge over time. The institution so chosen is to be imposed as a constraint, as a rule, under which particularized choices as to the content and the magnitude of public spending shall be made in a whole, indefinitely determinate, series of fiscal and accounting periods.2
The selection of a fiscal institution becomes closely analogous to the choosing of rules for an ordinary game. The player does not know, at the time when he must agree with fellow players on the rules under which the game shall be played, what particular set of rules will be privately most beneficial to him in subsequent rounds of play. He cannot know this with accuracy since he cannot predict what alternatives he will face, and he cannot know the constraints under which he must operate. The inherent uncertainty in choice among rules makes consensus among separate players much more likely to be attained than might otherwise be expected. If a potential player in an ordinary card game, at the time of agreeing on the rules for play, should be able to predict the cards that he will hold in each successive round of play, he will, of course, be quite definite as to his preferred set of rules, and he will fight very hard for the adoption of this set by the whole group. However, to the extent that other prospective players are equally omniscient, agreement on a single set of rules can never be attained.
On the other hand, if no prospective player can predict his own position in the various rounds of play anticipated, consensus on rules moves within the realm of possibility. In this situation, each prospective player will be motivated to select a set of rules that will seem “efficient” or “fair” in the private or individualized sense that, whatever may be his own position, he will stand a “fair” chance of winning. The central element of conflict among prospective players that arises once individual positions are identifiable is eliminated to the extent that such identification becomes impossible.
For our purposes, the game setting becomes that of choosing among fiscal institutions. How should the individual prefer to be taxed over a whole indeterminate sequence of periods in which spendings decisions will be made by the group if he knows neither what proposals will be presented and adopted nor what his own particular preferences regarding proposals will be?
From Private Interest to “Public” Interest
Throughout this book, and in earlier works, analysis has been grounded on the choice calculus of the single individual, as a choosing unit, and he has been assumed to act so as to maximize his own utility. This is not, of course, the appropriate place to discuss the general methodological implications of this approach, but one point should be made in passing. Political scientists, and others, often refer to “the public interest” as something that exists independently of the separate personal or private interests of the individual members of a community. The approach taken here does not recognize the existence of such a “public interest,” and individuals are presumed to act simply as utility-maximizers, although utility functions need not be narrowly defined.
The approach to fiscal institutions taken in Part II allows some reconciliation of the purely individualistic and the public-interest conception of political order. If the choosing individual is placed in the position of selecting among institutions, among alternative rules of the game, and if he cannot predict with any degree of accuracy his own particular position on subsequent rounds of play, his own private interest will dictate, as suggested above, that he indicate a preference for a set of rules that seems “efficient.” That is to say, his own utility-maximizing behavior will, in this setting, lead him to choose rules that will be efficient for the group, taken as a whole. And consensus among all members on a common set of rules becomes conceptually or potentially possible. The analysis suggests, therefore, that if individuals are appropriately placed in positions where they are required to choose “constitutionally,” they can be led, by their own self-interest, to act as if they are furthering the general or public interest in some properly meaningful sense. In this setting, no conflict arises between private utility-maximizing behavior and political obligation.
This conclusion has important normative implications, some of which will be discussed more fully in a later chapter. It suggests that where possible social choices should be made under conditions where individuals find themselves in such “constitutional” situations. The utility function of the individual chooser provides different signals for behavior in such situations from those that it provides when individual positions are more readily identifiable. No explicit incorporation of interpersonal considerations need be introduced; the utility function need not be changed so as to include arguments for either the utilities or the activities of other persons. However, because the reference individual may, in any subsequent “round of play,” assume any one of many specific positions, his own utility-maximizing behavior will lead him to select institutions that are generally efficient. And, since all members of the group may be in roughly similar situations, agreement on a generally efficient set of rules becomes possible.
The Question of Relevance
Are fiscal institutions actually chosen under conditions that remotely resemble those postulated here? Are institutional choices made separately from day-to-day choices? Exhaustive research into the political process is not required to establish the general conclusion that the models of decision do have considerable relevance for real-world events. Nothing more than everyday observation is required to reveal that fiscal institutions are debated, discussed, and finally selected quite independently of public-goods choices. For example, the political discussion on tax reform in the United States in 1963 and 1964 was carried on largely without any consideration of the choices of spending programs that might be consequent to the reform. In part this partitioning of the fiscal decision process may well be due to fundamentally irrational or inefficient elements, and a greater allowance for the real interdependence among fiscal variables at all levels might well be highly desirable. The effects of one aspect of this partitioning have been discussed in Part I. The independent consideration of the institutional choice tends to impose constraints on ordinary budgetary choice, and, because of this, to generate inefficiency of the standard sort. If, for example, a proposal is made for a particular spending program to be financed under an existing, and presumably nonadjustable, tax structure, the required support may not be generated, despite the fact that, should some alternative tax distribution be introduced, support would be readily forthcoming.
The considerations advanced in this chapter suggest, however, that such admitted inefficiencies that stem from the independence of institutional and operational choices may be offset, at least in certain cases, by the greater efficiencies of decision-making under the fully partitioned system. A priori, it seems impossible to say that the whole fiscal choice process should not, ideally, involve a distinct conceptual separation between the institutional set of decisions and the ordinary or day-to-day operational set. The facts are that we observe such separation in almost all political jurisdictions.
A Rehabilitation of Traditional Neoclassical Public Finance?
The classical and neoclassical theory of public finance, especially as this has been developed by English-language scholars, has been criticized for its emphasis on the tax side of the fiscal account and for its relative neglect of the expenditure side. Analysis in this tradition proceeded as if taxes are exogenously imposed and as if revenues were drained out of the economy upon collection. Einaudi’;s term, “imposta grandine,” which, literally translated, means “hail-storm tax,” is properly descriptive of the standard models. So-called “principles” of taxation were developed, and arguments on the basis of these continue to be presented in sophisticated discussions of taxes, without regard to the expenditure side of the budget.
This procedure amounts to an attempt to lay down “principles” for distributing the costs of public goods among individuals independently from any consideration of the demand for such goods. In the market for private goods under certain conditions, the prices that must be paid by individual purchasers are determined primarily by costs, and individual demands influence only the quantities that shall be taken. In this case, demand affects the total outlay on goods, but not the price per unit of good supplied. With public or collective goods, jointness in supply is the essential characteristic. This implies that it is impossible to provide divisible units of these goods to “purchasers” at cost-determined supply prices; individual quantity adjustment cannot take place. Cost elements can determine the supply prices confronted by the group as a unit, not those confronted by individuals. The uniformity in quantity that is made available to all individuals in the group makes necessary an apparent discrimination in “prices” charged to the various demanders, and the appropriate discrimination here can only be determined by bringing the demand side explicitly into account. The neglect of this side in deriving the so-called “principles” of taxation produces wholly arbitrary results.
I have argued in other works3 that the arbitrariness here is reduced to the extent that all public goods and services provide “general” rather than specific benefits. If public outlay is limited to providing only those goods and services that are made available equally to all members in the community, the neoclassical models of analysis become somewhat less one-sided than initial reflection may suggest. This is especially true if specific benefit imputations among individuals are made and accepted to be reasonably descriptive. The making of such imputations incorporates the demand side into the model, but it may do so in such a manner that allows primary concentration on the allocation of costs. If, for example, it is accepted that the marginal benefits from the enjoyment of public goods and services are roughly equal for all individuals, differences in this side of the account do not affect the distribution of tax-costs, regardless of the norms that may be accepted. In such a model, all individual demands for public goods are roughly equivalent. Hence, efficiency considerations would dictate a structure of tax-prices equal for all persons. Discussion as to “principles” for distributing taxes then becomes one of the degree to which nonefficiency norms are relevant.
A different imputation of marginal benefits may be one where these are roughly proportional to some income-wealth base. In this case, efficiency considerations alone dictate proportional income-wealth taxation, at the margin, and departures from this rule could then be discussed in terms of nonefficiency versus efficiency norms. Still other possible marginal benefit imputations might be employed, and each would, of course, yield different “ideally efficient” distributions of marginal tax-prices.
We know, however, that the traditional approach contains few attempts to justify the empirical relevance of any of the benefit imputations required to legitimatize its methodology. Secondly, we know that the public goods and services actually supplied by governments do not fully qualify as “general” in the sense indicated. For some such goods and services, benefits, both total and marginal, are differentially made available to individuals and subgroups within the larger community. When this is recognized, the traditional neoclassical approach to tax principles seems to contain little that is worth preserving, and scientific advance seems to require that it be discarded.
This reaction, upon more careful consideration, seems premature. The institutional approach that Part II of this study opens up serves to rehabilitate, in a qualified sense, the neoclassical methodology in general terms, if not in its specific logic. At least in some circumstances, it may prove desirable and efficient for the choice among the institutions of taxation to be divorced from the choice among spending programs. The argument for such a partitioning of the fiscal decision process is based on the presumption that the institutions of taxation, which determine the distribution of the costs of providing public goods and services among members of the group, may be quasi-permanent or “constitutional” elements of the political-social structure whereas spending programs, which determine the distribution of the benefits of public goods and services among the members of the group, may be relatively impermanent or temporary phenomena. Whether or not this distinction is empirically relevant can only be determined by real-world events. But to the extent that it becomes so, we may discuss the individual’;s calculus of choice among tax instruments quite apart from any specific assumptions about the spending side.
A simplified example will both clarify the setting and suggest its limitations. Assume that a political community contains only three citizens, A, B, and C. There are three possible public spending programs in each fiscal period. One of these benefits A and B equally, but provides no benefit at all to C. A second program benefits A and C equally, but provides no benefit to B. A third program benefits B and C equally, but provides no benefits to A. Assume now that each individual considers the adoption of these three programs as being equally probable in each fiscal period. Under such circumstances as these, it seems rational for any individual in the group to discuss with his fellows the introduction of a general scheme for collecting taxes, quite independently of the particular benefit imputation anticipated in any specific period. Over time, the probability distribution of benefits to be enjoyed from various spending programs may be unknown, but this element of uncertainty itself is sufficient to make separate institutional choice rational. It must remain “inefficient,” perhaps grossly so, in some short-run or one-period sense, for the individual who enjoys no benefits at all from particular spending programs to be subjected to tax-costs equal to those imposed on his fellows, who are direct beneficiaries. But the acceptance of the institution of taxation may, in the multiperiod setting, become “efficient” in the long-run sense provided only that the individual in question expects to get his own “fair” share in the differential benefits from public services as the tax institution remains in force over a whole unpredictable sequence of spending choices.
In this chapter income-tax progression will be examined in the constitutional-institutional framework introduced in Chapter 14. Under what conditions, if at all, will the individual choose a tax structure that embodies rate progression on an income base?
This analysis may be clarified by its contrast with the traditional approach to income taxation. In the latter, progression in a rate structure is explicitly discussed in terms of externally selected ethical norms. That is to say, progression is either justified or attacked on grounds of its agreement or contradiction with a set of norms for fiscal organization that are chosen by the observer, who conceptually stands outside the whole system. Modern economists have advanced in sophistication over the English utilitarians in that they have recognized the necessity of introducing such norms. Henry Simons, who followed Adolf Wagner in this respect, openly and avowedly based his own argument for progressive income taxation on the desirability for greater income equality among persons and families, a social objective that the fiscal structure “should” be organized to promote.1 More recently, such scholars as Paul Samuelson2 and Richard A. Musgrave3 have distinguished the redistributive function of the fiscal mechanism sharply from the allocative function, and, for the former, they have suggested the necessity of introducing external ethical norms.
Progressive income taxation can be fruitfully discussed in such terms. Nevertheless, it is also true that, to the extent that value judgments enter the discussion, genuine “scientific” analysis comes to an end. It follows that if progression, or any other institution, can be discussed meaningfully without the introduction of external norms there are net methodological gains. This is not, of course, to suggest that normative discussions cannot be helpful. I suggest only that such discussions can best be postponed until analysis on a prevalue basis is fully exhausted.
What the institutional-choice approach does is to allow progression to be examined in an individualistic reference system. That is to say, we are enabled to analyze the choice calculus of the individual as he evaluates alternative tax structures, one of which is a progressive tax on income. It is not necessary to assume a position as external observer, and progression need not be discussed only in terms of its impact on a set of separate persons at different income levels. One way of putting this point is to say that, whereas orthodox analysis has considered progression largely, if not exclusively, in terms of redistribution among persons, the analysis here allows progression to be treated as one among several alternatives of individual choice. Both the proponents and the opponents of the neoclassical utilitarian argument in support of progression, including its modern counterparts, have overlooked the fact that interpersonal comparisons of utility need not be introduced. Progression has been discussed almost exclusively in terms of the relative tax loads imposed on Tizio and Caio. The analysis here transforms the problem into one of choice among institutions faced by Tizio alone.
What makes this difference possible? The orthodox model requires that attention be devoted to single, isolated events located precisely in time rather than to a series or sequence of events extending over time. Implicitly the standard analytical model assumes that relevant choices are among uniquely timed events. The traditional posing of the tax problem is: If the government must raise X dollars of revenue in Period t0, how much of this sum shall be raised from Tizio and how much from Caio? Progression, proportion, regression, and other terms descriptive of a rate structure are taken to refer to comparative rates imposed on the separate persons, these being, in turn, arrayed with respect to some income or wealth characteristic.
A cursory examination of real-world political process suggests that tax issues are rarely, if ever, presented in so simple a manner as the traditional discussion suggests. Tax institutions are selected independently of spending programs, but, also, choices are made among instruments that are expected to remain in being over an extended and usually intermediate number of fiscal-accounting periods. When this fact is acknowledged and when its implications are incorporated into the analysis, the question of rate structure can be treated as a problem of individual choice, and the utilitarian dilemma of interpersonal incomparability at least partially resolved. There can exist an individual choice among tax instruments, all of which may, in any one specific period, subject the taxpayer to the same charge.
Before comparison can be meaningful, however, alternatives for choice must be made roughly equivalent in quantitative impact. Familiarly, economists have employed the equal-yield assumption as a means of evaluating various taxes. Since the model to be used here implies a whole series of time periods, we may adopt the constraining assumption that the tax alternatives to the individual embody equal present values of future tax obligations. This provides a substitute for the equal-yield-per-period model of orthodox analysis. With this assumption of equal present values we can proceed directly to discuss the individual’;s choice among various tax instruments, independently of the positions of other individuals, at least initially. The following section develops the analysis under conditions of certainty. In a later section, uncertainty is introduced, with interesting consequences for the results.
Institutional Choice Under Certainty
Consider now a political community faced with the problem of choosing a tax institution independently of public expenditure programs. To simplify the analysis, we shall introduce an assumption with regard to the spending side that will enable us to limit discussion to the tax side. The community is faced with the necessity of meeting an annual interest charge of X dollars on a deadweight public debt. We assume further that, through some collective decision rule, the distribution for the liability of meeting this debt service obligation has been determined, not for any specific period, but rather in terms of some specific assignment of present-value liabilities. Each person has assigned to him a defined share in the total community liability that the necessity of servicing the debt represents. This rather unusual assumption allows us to neglect initially the whole question of distribution of tax shares among separate persons.
In the private economy, when an individual is confronted with a fixed present-value liability, we do not normally think about his selecting or choosing an institution of payment, although we recognize, of course, that different individuals will meet such obligations differently. Some will act to discharge the obligation immediately; others will schedule regular payments over time; still others will only service the outstanding debt, leaving the principal sum unchanged. The private economy is organized so as to allow each person wide degrees of freedom in choosing privately the most preferred means of meeting an obligation of this nature. Conceptually, we could think of separate individuals meeting their own shares in a public or aggregate liability individualistically and voluntarily. Each person in our model, assigned a specific share in the liability represented in the public debt, could select his own means of payment, and different persons could be allowed to select different instruments.
We move somewhat closer to fiscal reality, however, if we require that all members of the group meet their obligation under the same institution of payment. Let us limit consideration to three fiscal alternatives: an annual tax of equal amount each year, a proportional tax on income, and a single progressive tax on income. We define these three alternatives in such a way that the reference individual, any member of the group, is presented with the same present value, this representing his own assigned share in the total community liability. These present-value liabilities must be defined with respect to an objectively determined discount rate, which we postulate to be that rate at which the collectivity, the government, can borrow funds in the market. If, instead of this, some subjective or personal rate of discount should be used, equality in present values would simply be another way of defining the three alternatives to be equally preferred by the individual. Choice would be eliminated, which is precisely what we want to examine. In addition, the total of individual liabilities need not add to the total community liability under this sort of computation. If, however, present values are computed by some objective discount rate, equal for all persons, then equality in these values for the three separate fiscal alternatives need not imply that the individual will be indifferent among them.
Faced with the choice posed in this model, the individual will first consider possible resort to the capital market, either as a lender or as a borrower of funds. If this market works in such a way that allows the individual to lend funds or to borrow funds at the same rate at which the government borrows, the individual’;s own subjective discount rate will be brought into line with that rate which is employed in defining the liability. In such a case, he will remain wholly indifferent as among the three tax alternatives, regardless of his anticipations as to income and spending needs, because he can, at no net cost, convert any one time stream into any other. His own most preferred time stream of spending will not, in this case, be affected at all by the choice of the tax instrument that is imposed on all members of the group. If, however, the capital market does not operate so as to produce these results, the individual may be led, by ordinary utility-maximizing considerations, to prefer one of the three taxes to the others. If he cannot lend funds or borrow funds at the objective discount rate that is used to define the liability with which he is confronted, but must, instead, lend or borrow at different rates, he will prefer that fiscal alternative that will minimize the distortion from his own optimal time stream of spending.
It is reasonable to assume that the individual can always lend funds at the government borrowing rate; he may do so by purchasing government securities. However, private individuals cannot normally borrow at rates equal to those at which governments can borrow, for obvious reasons. Some differential over and above this rate must be paid. If this direction of difference is accepted, and if the individual expects his income to rise over time, rational choice will dictate that he “vote for” meeting his obligation through the progressive income tax, provided only that his planned or preferred stream of private spending is more uniform than that of anticipated income receipts.
A Numerical Example
Assume that the reference individual knows with certainty that he will receive $1000 in the current time period t0, and that he will receive $2000 in the following period t1. We limit the analysis to two periods. Assume now that a total fiscal liability, defined at the beginning of t0, amounting to $976.19 is assigned to this individual. The discount rate is 5 per cent.
This obligation may be met by a tax of $500 in each of the two periods; by a proportional tax levied at 33.6 per cent of income received in each period; or by a single-step progressive tax on income in each period, with a rate of 50.6 per cent on all income above a $500 exemption. This third alternative is, of course, only one among many possible progressive rate structures. It is chosen here because of its numerical simplicity. The details of the situation are set out in Table 15.1.
This numerical example makes it clear that if the individual’;s preferred time stream of private spending is more stable than his anticipated income stream, the tax obligation can best be met through the progressive levy. This allows him to meet a disproportionate share of his liability during the period when his income receipts are high, thereby eliminating or reducing the necessity of his entering the loanable funds market to borrow at private rates of interest. In effect, the progressive tax scheme allows the individual to “borrow” from the government, at the public borrowing rate, by postponing his tax liability through time.
This model need not be nearly so restrictive or rarified as the various assumptions make it seem. The essential requirements are that desired or planned private spending be related in some way to permanent income rather than to annually measured income and that the latter be expected to increase over time. Both of these seem plausible enough, and both have been supported by empirical evidence.
As presented in this model, we have assumed that public spending in each period is limited to servicing a deadweight public debt. It is easy to see that this assumption can be replaced by one that allows public spending on almost any mix of collective goods, provided that the individual does not expect, on the average, to be benefited differentially. In other words, the analysis holds without change if the distribution of benefits from whatever public services that may be provided is expected to be determined on some essentially random basis.
From Individual to Group Choice
The whole analysis remains highly restricted, however, in that it is applicable to the choice problem as this might be faced by the single, isolated individual. To be relevant for policy discussion, the analysis must be extended to the collective outcome for the whole community of persons.
A difficult adding-up problem arises when we shift from the isolated individual decision calculus to that of a group of individuals. Assume, now, that the collectivity, as a unit, must reach agreement as to one of the three fiscal alternatives. This outcome, once selected, will be then imposed on all individual citizens. We want to examine the process through which agreement might be attained.
If we continue to assume that each person has assigned to him a fixed share in some total community liability, or else a fixed proportion of variable aggregate liability, general agreement among large numbers of people seems possible. This is because, for the majority of taxpayers, incomes will be expected to grow over time, and private spending patterns are, ideally, more stable than income receipts. However, it becomes clear that by continuing to assume away the basic distributional issue at this stage, we are neglecting the central and indeed the critical problem in tax choice.
Assume, therefore, that there exists no such pre-choice assignment of personal fiscal liabilities, even in present-value terms. Instead, we now assume that the whole group, as a collectivity, must reach some decision on assigning the appropriate shares as well as some decision on the tax institution through which the individual tax bills are to be paid.
Regardless of the prevailing set of rules for reaching collective decisions, whether this be Wicksellian unanimity, simple majority voting, or something different, the problem quickly becomes one that is dominated by pure bargaining and the results are, of course, unpredictable. Presumably, some allocation of shares among persons will be chosen, but a great amount of investment in strategic bargaining effort may be observed to take place. Once a bargain is struck, once a “solution” as to the proportionate shares is reached, the individual calculus discussed above might come into play. Here the individual, whatever his final lot in the bargain, should rationally prefer to pay his share through the institution of progressive income taxation, given the suggested side conditions. In the process of bargaining on the assignment of shares, however, the institutions for collecting revenue take on wholly different characteristics from those that these same institutions possess in the individual calculus. It is this interdependence between the bargaining on shares in the tax bill, the distributional problem, and the efficiency problem that confounds both choices, and the analysis of choice, here. Because of this interdependence, tax institutions become means of assigning shares.
If it were possible to conceive of a separate bargaining process in which liability shares are assigned, but where the choice among institutions of payment is not settled, the distributional and the efficiency aspects could be distinguished. Interdependence almost necessarily arises, however, especially when additional constraints and side conditions are placed on the structure of the bargains or the workings of the institutions of payment. The individual who should, rationally, prefer the progressive income tax as the efficient means of meeting his own share of community liability may, also rationally, oppose this tax if a side condition is imposed to the effect that rates of tax must be uniform over separate persons. Through such conditions as these, the tax alternatives necessarily become counters in the bargaining game.
A Numerical Example
An extension of the earlier numerical example, summarized in Table 15.1, will clarify this somewhat complex point. Assume now a two-man community, and, as before, a two-period sequence. The first man, whom we may call A, is the one whose income prospects have been set out in Table 15.1. The second man, whom we shall call B, anticipates a somewhat lower income stream than his fellow citizen; B’;s income prospects, again assumed to be known with certainty, are set out in Table 15.2.
Let us, for now, assume that the distributional or share-assignment problem has been resolved and that B has a present-value liability of $748.80 as compared with A’;s, $976.19. Note that this figure for B is computed by imposing the same proportional rate on measured in-period income as that imposed on A under this alternative, or a rate of 33.6 per cent. As with A, B should also “prefer” to meet this obligation through the payment of a progressive tax, as Table 15.2 shows, with the suggested side conditions. If we choose the same form of this tax as that discussed with reference to A’;s choice, a single-step progressive structure, with a flat rate above the $500 exemption, B must pay a rate of 59.7 per cent. Note that this exceeds the comparable rate for A, which was 50.6 per cent.
The interdependence between the share-assignment problem and the institutional efficiency problem is evident in the example. It is not possible that both uniformity in rates among separate persons and predetermined liability shares can be maintained over more than one tax alternative. In the example, an equalization of proportional rates, as between the two persons, implies discrimination in progressive rates that would generate the same present-value revenues. The converse also holds, of course. An equalization of progressive rates would imply some discrimination in proportional rates.
The individual or group with the higher-income anticipations, A in the example, will bargain for a distributional solution that reduces his own liability. In so doing, he will find that distributional advantages can be secured through the selection of tax institutions themselves under the side condition of rate uniformity. Recognizing this, A will argue in favor of the imposition of uniform annual taxes, or the institutions nearest to this alternative that seems practicable. Individual B, in the example, the person with the relatively low income prospects, will behave in the opposing fashion. He will argue for the progressive tax, under the most extreme rate structure possible. Individual A, the high-income receiver, finds that distributional and efficiency objectives come into conflict, and, in the normal case, the distributional elements assume considerably more importance. Hence, we should expect the traditional intergroup conflicts over tax institutions. The individual who expects to receive the relatively higher income is led to support the selection of fiscal institutions that are inefficient because of the nature of the political bargaining process in which he must engage.
At this point, our whole analysis seems to be back where it started. If a “social compromise” or “agreement” on tax institutions cannot be worked out without the introduction of purely distributional considerations, the tedium of analyzing the decision calculus of the single, isolated individual may appear to have been useless. To say that, if he could separate the efficiency considerations out, the individual should rationally prefer the progressive tax, really says nothing at all if such a separation is shown to be impossible when participation in group choice is introduced.
Fiscal Choice Under Uncertainty
To this point in the analysis, however, the individual has been assumed to be able to predict future income receipts with certainty. The analysis is interesting here in that, when uncertainties are introduced, some of the complex interdependencies tend to disappear. In a certain world, where separate individuals and groups expect particular patterns of income over a series of time periods, the distributional elements of a choice among tax institutions can rarely be put aside. This feature is, however, modified dramatically when individual choice is assumed to take place under uncertainty in regard to future income prospects.
Again it is useful to consider a simplified example. And for present purposes, we need not consider a time sequence at all. Take an individual who faces what he estimates to be an equal probability that he will receive an income of $1000 or $2000 in the current period; he assigns a subjective probability of one-half to each of these prospects. We need now only to assume that his most preferred pattern of private spending is more predictable than his income receipts in order for the analysis developed to hold without qualification. Suppose that we postulate that the individual is to be subjected to a tax which carries a certainty equivalent of $100 and that he desires to maintain a private spending rate of $1400 per period. If he selects an invariant tax, unrelated to actual income receipts, he agrees to pay the flat sum of $100 regardless of his income event. If he selects a proportional tax on measured in-period income, he has a probability of one-half of paying $132 and a probability of one-half of paying only $66. On the other hand, suppose that he chooses a single-step progressive levy, with all income above $1000 exempted from tax. Under this fiscal alternative, he has an equal chance of paying $200 and of paying nothing at all. In the case of low-income realization in the period, his resort to the capital market is minimized under the third alternative. It seems clear that he should, rationally, opt for this scheme.
This single-period model is, of course, highly unrealistic in all respects. If we incorporate uncertainty as to income prospects into a multiperiod model, a more relevant choice situation emerges. In this case, the individual will tend to choose among tax alternatives on the basis of efficiency criteria. Distributional aspects are eliminated to the extent that the individual cannot predict the shape of the bargain that will, in fact, yield him maximum gain.
It is not reasonable to assume that the individual is uncertain as to income prospects in the near future except, of course, to a limited degree. He will tend to know with some accuracy what his income prospects are over a succession of periods subsequent to choice. But it is surely reasonable also to assume that income uncertainty increases as plans are projected forward in time. This implies that the efficiency elements in fiscal choice become relatively more important as longer and longer time horizons are introduced. It becomes possible, in this manner, to conceive of situations in which distributional considerations come to be effectively swamped by efficiency considerations in the individual’;s own calculus of choice among the tax alternatives. If, for example, we think of a group confronted with an aggregate fiscal liability over time (the benefits from public expenditure programs being distributed in some unpredictable fashion), with each member of the group wholly uncertain as to his own income prospects beyond some intermediate period, each individual may, quite rationally, prefer that the collectivity adopt the institution of progression with specific rates to be levied on all who may qualify as taxpayers by the designated income criteria. This agreement on the choice of a tax institution may take place despite the fact that each individual recognizes that, should he happen to receive the relatively high income, he will bear a major share of the aggregate tax load through time. In such a decision model as this, the problem of assigning shares among persons whose future income prospects are clearly identifiable cannot arise, and each person is led by utility-maximizing considerations to opt for that institution of payment that he thinks will be most “efficient” given some probability distribution of his income expectations in future periods.
Institutional Choice in the Real World
As we have noted, choices in the real world are not made for each period separately. Institutions are selected as if they were semipermanent. This suggests that elements of both the certainty and the uncertainty models may be present in the normal individual calculus. It is reasonable to suggest that at least some measure of the popular support for progressive income taxation in Western democratic societies has been based intuitively on some such “efficiency” calculus as that outlined in this chapter, in contrast to purely distributional motivations.
There are several features of the prevailing institutional structure that confirm this suggestion. For one thing, explicit redistribution of incomes, as such, is not normally introduced into the political commentaries on rate progression, nor, indeed, is this present to any large extent in the fiscal system as it actually operates. Instead of being employed directly as a means of transferring general purchasing power from the rich to the poor, the progressive income tax produces revenues for the financing of “general” or “collective” purposes. The result is, in many cases, net redistribution, but this remains a result, rather than an openly avowed aim except in relatively special circumstances. The sequential model of choice is confirmed by the fact that tax proposals are usually discussed, not as unique annual allocations of fiscal charges, but as quasi-permanent features of a continuing institutional structure. Temporary taxes are explicitly designated as such in the discussion.
All this is not to suggest, of course, that redistributionist arguments or objectives have been absent from the practical political discussion of tax alternatives, on the side of either the supporters or the attackers of progression. The point is rather that there may have been an undue emphasis on the redistributional elements in the choice among fiscal institutions, and perhaps especially by public finance scholars. When models that reflect the actual choice situations more carefully are used, nonredistributional aspects assume considerable importance, and progressive income taxation emerges in a somewhat different light. Egalitarian aims, explicitly avowed as ethical norms, need not be introduced to “defend” the institution of progression, or to “explain” its acceptance in modern fiscal structures.
Again it must be noted that the analysis in this chapter is not intended to be an exhaustive treatment of income-tax progression, even in the reference system of individual institutional choice. The purpose has been that of demonstrating the efficacy, or potential efficacy, of approaching some of the familiar institutions of the fiscal system in terms of the choices that must ultimately confront the individual taxpayer as he participates in some quasi-constitutional collective choice among several fiscal alternatives. The analysis has shown that under certain conditions progressive income taxation may be rationally preferred by the individual, and, at least to some extent, these conditions embody features of real-world institutional choice.
The required conditions may not be present in many circumstances, and the choice behavior of the individual may be predictably different from that suggested above. In the following chapter, we shall outline a set of conditions only slightly different from that postulated here and demonstrate that the individual may choose to pay his fiscal obligations through specific excise levies. Exhaustive treatment would require that many sets of possible situations of choice be examined. As an example, in the models of this chapter, income receipts have been assumed to be determined more or less externally to the individual’;s own decisions about earning income. This means, of course, that the models have ignored the whole issue concerning the possible effects of progression on incentives to earn taxable income, an issue that has been central to much of the traditional discussion. Alternative models could be introduced in which the individual is assumed to be able to vary the amount of taxable income earned in each period. An extreme model of this variety might allow the individual to adjust income precisely to spending plans in each period. In this case the efficiency argument in support of progression would not hold. If, however, the individual is allowed to vary his income receipts only within relatively narrow limits, and if his preferred stream of private spending is somehow independent of his measured in-period income receipts, the efficiency argument must enter his evaluation. To the extent that the individual, when confronted with institutional choice, does recognize that his own income-earning choices during future periods will be influenced by the tax alternative in existence, and that the progressive tax will introduce differential effects in this respect, the efficiency argument in support of progression is reduced in weight. Even here, however, there may be situations in which the individual will prefer the progressive tax to its alternatives. The distortions in the individual’;s intertemporal income-earning pattern may be more than offset by the relative improvements in his intertemporal income-spending pattern that progression may allow.
If the basic analysis of this and the following chapters is accepted, certain normative implications follow with respect to fiscal reforms. First of all, the advantages that may be secured from having fundamental decisions on the fiscal structure discussed, enacted, and implemented as quasi-permanent changes, whose effects are expected to endure over a long series of fiscal-accounting periods, become clear. To the extent that the individual as a potential taxpayer and as a participant in collective decisions considers the long-run implications of his choices, the purely distributional influences in these choices tend to be damped. A second, and perhaps more important, general implication that emerges from the analysis is the possible significance of social-economic mobility in affecting individual choice behavior. In a society that is descriptively characterized by the pervasiveness of the “log-cabin myth”; that is, one in which expectations of future income prospects among the young, generally, are buoyant over large subgroups, the distributional aspects of fiscal decisions tend to become secondary. By contrast, in a society that is characterized by a hierarchy of class distinctions which imply corollary income expectations, even relatively permanent decisions among fiscal alternatives may primarily involve issues of interclass or intergroup equity.
There are also important philosophical implications to be drawn from this exploratory discussion of progressive income taxation. If the efficiency-under-uncertainty argument is wholly rejected, as might appear to be the case in some scholarly discussions of progression, the nature of democratic political society itself is called into question. This is a subject about which social scientists, and especially economists, have remained strangely silent. Implicitly, as Wicksell suggested, they have been content to assume a benevolent despotism, a central decision-making authority, the “men in Washington or Whitehall,” who, somehow, know what is “best” for other members of the community. This dirigiste vision or model of political order is useful in certain contexts, as we have suggested, but it is at odds with effective democratic process, as this latter has been traditionally interpreted. Once this simple point is recognized many of the policy aspects of modern economic analysis cease to have relevance.
In this book the collectivity is viewed as a set of individuals who seek to arrive at joint decisions for the achievement of mutually beneficial objectives. In this model or vision of political order, the whole manner of looking at most matters of economic policy must be significantly changed. Here we simply are not allowed to introduce external ethical norms to resolve issues of conflict that arise. We cannot rely on an externally imposed objective of “equality,” or upon a “social welfare function” to inform decisions about the basic fiscal structure. Somehow, and in some fashion, we must try to evolve collective agreements out of the rational calculus of men as they participate in governmental choice processes. If, in these, men are considered, and consider themselves, purely in terms of immediate and identifiable economic position or status, analysis reduces, simply and quickly, to that of coalition formation. Social and collective decisions represent solutions to zero-sum games, and, as is the case with all such games, one is prompted to ask why the losers continue to play. The answer is, of course, that they enjoy playing and that the game is held to be reasonably “fair” in that losers continually expect to win in subsequent rounds of play. But purely redistributional outcomes are difficult to think about in these terms; the collectivity becomes, all too readily, a means through which the politically strong can exploit the politically weak.
A more encouraging, and in some respects a more realistic, vision of social process emerges from the analysis developed here. The political game is not zero sum; it is, like the economic game, positive sum. Individuals, in their capacities as participants in basic fiscal decisions, are acting without full knowledge of their own shares in the financing of general public services over time. The game has not really been played at the time the rules are chosen, and the levy of progressive income taxation may be somewhat analogous to the familiar “big winner buys the drinks” comment heard at the onset of many a parlor poker game.
Specific Excise Taxation†
How should taxes be paid? This question has been discussed for centuries, and will continue to be discussed for centuries more. It has not been resolved, either in the formal theory of public finance or in the practical structure of modern fiscal systems. In this chapter, as in the one preceding, this old and familiar question is asked in what is essentially a novel setting. How would the individual prefer to meet his tax obligations over time if he must choose among fiscal alternatives as quasi-permanent institutions? The earlier chapter examined the standard direct tax alternatives. Here the direct tax-indirect tax problem will be analyzed, a problem that continues to occupy an important position in the literature of fiscal theory.
In recent decades, the choice between direct and indirect taxes has been discussed in terms of the now-famous excess-burden theorem, initially stated by Barone,1 later elaborated many times, and, more recently, subjected to several criticisms. Broadly speaking, it seems correct to say, despite the acknowledged relevance of second-best arguments, most modern scholars would accept the view that, other things equal, direct and general taxes are to be recommended over indirect and specific taxes on both equity and efficiency grounds. Employing the methodology previously applied, I shall demonstrate that this widespread conclusion cannot be supported. As was the case with income-tax progression, the purpose of the analysis is not to defend specific commodity taxation, per se, but to use the traditional direct tax-indirect tax comparison to illustrate the efficacy of the general institutional approach to fiscal choice.
The One-Period Argument Summarized
Almost without exception, the direct-indirect tax comparison has proceeded on the assumption that a choice between tax instruments must be made only in a one-period setting. To my knowledge, no attempt has been made to extend the comparison to a multiperiod or long-run setting; no one has assumed, for analytical purposes, that the tax instrument chosen shall remain in effect over several income- or fiscal-accounting periods. The introduction of such a temporal sequence, along with the concentration on individual choice behavior, is central to the analysis that will be developed. Initially, however, it will be useful to examine briefly the standard one-period model.
Barone demonstrated that, for the individual taxpayer, a direct tax should rationally be preferred to an indirect tax of equal yield. His argument has become one of the textbook examples of indifference curve economics, and it need not be repeated here. Little showed that, strictly speaking, the Barone conclusions follow only when a lump-sum tax is compared with a specific commodity tax.2 Friedman3 and Rolph and Break4 showed that the Barone theorem could be extended from the single individual to the whole community only if all of the remaining conditions necessary for Pareto optimality should be satisfied. These criticisms, which may be summarized as those deriving from second-best arguments, need not affect the analysis to be developed here, since, initially at least, the latter does not go beyond individual choice. In the restricted one-period model, the rational person will always prefer the direct tax over the indirect tax of equal yield for the simple reason that he can in this manner enjoy the widest range of choice.
In order to relate it to the subsequent discussion, the one-period question may be put as follows: Should the utility-maximizing individual, confronted with a determined tax liability, choose to pay this liability through a lump-sum payment, a proportional tax on income, a progressive tax on income, a general tax on consumption expenditure, or a specific tax on the consumption of one commodity? In such a model, the first alternative provides the widest area of choice. The lump-sum tax will be preferred over the proportional income tax which will, in its turn, be preferred over the progressive tax which introduces an additional element of discrimination. The latter tax will, in its own turn, be preferred over the general expenditure tax. And, finally, the tax on a specific commodity becomes the least desired of the lot; it produces the largest distortion in the pattern of earning-spending behavior. These familiar conclusions hold, however, only if the individual is allowed to select among fiscal alternatives separately in each discrete period of time or if the results can somehow be generalized to apply to a sequence of time periods.
Choice Through Time
Let the same question be posed, only assume now that the fiscal alternative, once selected, must remain in force over a whole series of periods, t0, t1, ... , tn. As was the case with the analysis of progression, it will be useful to develop initially a certainty model. Hence the individual is assumed able to predict with certainty, at t0, what his income receipts will be in each of the periods, t1, t2, ... , tn. We shall also assume that his decision, at t0, reflects consideration of anticipated fluctuations in spending plans over time. Viewed from t0, his preferred spending pattern over the whole time sequence is known with certainty; this pattern need not, of course, exhibit uniformity in time.
The choice calculus to be analyzed here is somewhat more complex than that required for the preceding chapter. It is useful, therefore, to establish some general principles of rational behavior for the individual before posing the fiscal decision issue specifically. For convenience, we may assume that the individual saves only in order to retire debt or to accumulate funds for future consumption spending. This is a life-cycle model of saving behavior that is similar to those suggested by several economists in recent years.5 In such a model, the present value of the income stream, at t0, is equal to the present value of the planned outlay or spending stream.
To avoid confusion, it is first necessary to distinguish between spending on items of consumption and actual consumption of these items. For simplicity here, assume that these acts are simultaneous. This implies that the services of all durable consumption goods are purchased or leased as consumption actually takes place. We now break down consumption spending into two provisional categories, the dividing line between which cannot be rigorously defined. The first includes those consumption services designed to meet what may be called “basic needs.” The second category includes those services that are purchased with a view toward meeting “residual needs,” which are, in some sense, less urgent than those in the first category. Despite the admitted arbitrariness of any dividing line here, some such order of priorities must exist for almost any individual or family unit. Some needs must be met in the normal order of affairs; others may be met only if the opportunity (in part determined by income) arises.
Orthodox rationality criteria suggest that the individual should equalize the utility per dollar spent on each consumption service in each period. This may suggest that any attempt to distinguish between “basic” and “residual” items is misleading. If income fluctuates over time, however, casual observation indicates that residual items are, in fact, purchased and consumed only in periods of relative affluence. Such behavior would, nonetheless, be irrational in a world of perfect certainty. Here the individual would, through his saving activity, attain results that would be closely similar to those attained under a stable income flow. He should, in other terms, equalize the marginal rates of substitution between any two items of consumption for all time periods, viewed from the planning moment, t0, independently of predicted fluctuations in income receipts or in spending needs, on the assumption that price ratios remain invariant over time. If needs vary as among separate periods, this equalization need not, of course, imply equal consumption flows of either service in separate periods of time.6
Viewed from the moment, t0, the individual will set out a pattern of saving and spending over the several periods such that, in each period, the marginal rate of substitution between any two goods, say, bread and coal, is equal to the ratio of their prices. If, as an example, we consider the two-season year as a sequence, the rational individual will plan his spending over the whole year to insure that his needs for bread and coal will be equally satisfied, in a relative sense, in each season. He will not skimp on bread during the winter merely because his needs for coal are great. Nor will he gorge himself in the summer because he need make no outlay on coal for current usage. He will, of course, save some share of his income during the summer to meet his varying need for coal over the whole sequence. The example suggests that either income or needs or both can fluctuate over a temporal sequence and that the individual must take such variations into account as he attempts to maximize the present value of expected utility.
After this digression, let us return to the problem of individual choice among fiscal alternatives. Examine now the same alternatives listed above for the one-period model, but assume a multiperiod setting. How will the individual choose to pay his taxes? Or, more correctly stated, how will he “vote” in a collective decision process, elements of interdependence being temporarily neglected? As in Chapter 15, assume either that the pattern of public spending is wholly unpredictable as to benefit incidence or that such spending is committed quite independently from the individual’;s choice calculus.
Exchange Through Time
The individual will consider his possible resort to the capital market. If this market works in such a manner as to allow the individual both to borrow and to lend at the governmental borrowing rate, the specific commodity tax remains the least desired among the fiscal alternatives listed. If the individual confronts this kind of market opportunity, no temporal distortion need be introduced in his spending stream under any of the tax institutions. Hence, he can simply array the various institutions in order of preference based on minimizing pattern distortion within each period, the setting for the one-period model. Here the one-period results are general; the lump-sum tax becomes the optimal fiscal device.
If, however, the individual cannot borrow at public rates, temporal distortion does become relevant. The objective of the individual is not modified. He will try, as best he can after the imposition of the tax, to maintain the desired equalities in marginal rates of substitution. Assume, now, that prior to his confrontation with tax choice, the individual attains a position of planning “equilibrium.” That is to say, he has formulated a pattern of saving and spending over time that will equalize the relevant marginal rates of substitution in the different periods, always viewed only from the moment, t0.7 He now confronts the tax obligation, which we assume he is able to quantify in present-value terms. He will try to choose that tax instrument which introduces, on balance, the least disturbance in his planned pattern of consumption spending over time. If both income receipts and spending needs are expected to be stable, the orthodox conclusions hold. If, however, we allow for some temporal fluctuations in either income receipts or in spending, these conclusions are modified. Temporal distortion must be considered, and the one-period results no longer are general.
If spending patterns are expected to be more uniform over time than income receipts, the progressive income tax will tend to be optimal as the analysis of Chapter 15 has shown. The question to be asked at this point is whether or not the general sales tax or the specific excise tax might not be preferred, even to the progressive income tax, on similar grounds. The answer seems clearly to be negative under the conditions outlined. Either of these taxes on spending would, in the model where spending needs are more uniform in time than income receipts, introduce familiar in-period distortion that is greater than that under any of the direct-tax alternatives. At the same time, these taxes would represent no improvement over the progressive tax on income in minimizing temporal distortion.
If, however, we modify the conditions and now assume that anticipated spending desires fluctuate more than anticipated income receipts, different results may emerge. For simplicity, assume that income is expected to be stable, but that spending is expected to fluctuate sharply from one period of time to the next. This suggests that, without some recourse to the capital market, the marginal utility of the individual’;s spending dollar will be expected to vary over time. If “imperfections” in the investing-borrowing market involve sizable costs, the final adjustment attainable by the individual may involve a consumption-spending sequence that allows for rather significant variation in the per-period outlay on certain residual consumption items. Under this set of conditions, a specific commodity tax, levied on a single item or set of items of residual consumption, may well minimize over-all distortion, and hence be preferred, even to the progressive income tax.
Rational behavior on the part of the individual who expects his income and his spending to fluctuate over time dictates that he adjust his consumption in time so as to “bunch” his usage of residual items during periods when the marginal utility of his spending dollar is low. He will plan to satisfy certain residual consumption requirements only during those periods when his level of spending is relatively low, or when his level of income is relatively high. This pattern of behavior need not violate any norms of rationality when it is recognized that temporal substitution among consumption services is clearly possible. Certain items of consumption are postponable, necessarily so. For example, the individual may “need” only one holiday each year. It is sensible for him to plan his holiday for a period when either income receipts are higher than usual or when his desires for remaining consumption items are lower than usual.8
If the individual does, in fact, tend to bunch spending on residual consumption items, an activity that is surely descriptive of real-world behavior, it seems evident that a tax on a specific commodity or service may, under the proper combination of circumstances, be the most desirable of all the fiscal alternatives posed. The familiar in-period distortion in consumption patterns may be more than offset by the advantages that this tax possesses in allowing the individual to concentrate his tax payments during those periods when the marginal utility of his spending dollar is expected to be low, and, conversely, to escape altogether tax payment during periods when the marginal utility of his spending dollar is expected to be high. The minimization of temporal distortion in the individual’;s spending plans which this tax instrument allows may more than offset the maximization of the in-period distortion that it also embodies.
As compared with the progressive tax levied on income receipts in each period, the tax on a single item of postponable residual consumption can allow for adjustment in tax liability for fluctuating levels of spending in addition to fluctuating levels of income receipts. To demonstrate this point by a simple example, assume that income receipts are expected to be uniform over time; a family anticipates that, over the next decade, t1, t2, ... , t10, it will receive an annual income of $10,000. The decade is taken to be the relevant planning horizon. During these years, a son is expected to be attending college during t3, t4, t5, and t6. Without any adjustment in the capital market, the marginal utility of this family’;s spending dollar will be higher during these four years than in other years of the decade. The progressive tax would, in this example with uniform income, require the payment of the same net tax during each year. But this family, if allowed to choose, might prefer to bunch its tax payments for the whole decade in the noncollege years, t1, t2, t7, ... , t10. It may do so, without recourse to the capital market either as net lender or borrower, if the tax should be imposed on some item or set of items of genuinely residual consumption spending, items that the family plans to purchase only during the noncollege years. For example, holidays in Europe may be projected for such relatively affluent periods. Despite the in-period or pattern distortion that a tax on European holiday spending would surely involve, such a tax might, over time, actually expand the range of choice open to the family in question, relative to the situation under any other tax alternative considered.
It is interesting to note that when the whole set of tax instruments considered are arrayed in some order of distortion, the general tax on all spending becomes the least desirable fiscal alternative. The specific tax on a single item, or set of items, of residual consumption spending allows tax liability to be bunched in periods when the predicted marginal utility of spending is low. The income tax, whether proportional or progressive, allows the liability to be spread equally over time in this example where income does not fluctuate. The general tax on spending, by comparison, would require that the family pay a higher total tax precisely during those periods when the “needs” for basic consumption items are greatest. This conclusion is perhaps noteworthy since it runs counter to the familiar argument that the general expenditure tax may be more “efficient,” in some sense, than the income tax because of the removal of discrimination against saving. The contrast in results here stems from the fundamental difference in approach to fiscal choice.9
Many other examples could be constructed by using differing assumptions about predicted fluctuations in income receipts and in spending plans over time. These need not be elaborated here since the main purpose of the analysis is showing that under some conditions the rational person may prefer to meet a fiscal obligation through the specific commodity tax.
The results of the analysis are strongly reinforced when we relax somewhat the rationality assumption. If moral scruples, the “Puritan ethic,” influence behavior in the direction of making individuals “live within their incomes” and cause them to consider “eating up capital” or “going in debt” to be repugnant or, at best, imprudent, the marginal adjustments necessary for achieving any planned “equilibrium” pattern of spending may not take place. The marginal rates of substitution among items of spending will not be equated in separate time periods, even when viewed from a single moment. As such departures from any rationally planned equilibrium become more significant, the possible advantages of the specific commodity tax become larger.
The rationally planned pattern of spending is, of course, one normative version of the permanent-income hypothesis, either in the limited horizon, life-cycle sense, or in the unlimited Ricardian sense. To the extent that empirical findings lend support to this hypothesis, in either form, the possible advantages of the specific commodity tax in minimizing temporal distortion in spending are reduced. To the extent that the findings suggest that individuals plan spending largely on the basis of current income receipts and not on permanent income, the relative advantages of the indirect tax instrument are increased.
To this point the individual, whose decision calculus has been analyzed, has been assumed certain as to his future income prospects, future spending needs, and the life of the fiscal alternatives considered. In any real-world setting, of course, uncertainty rather than certainty prevails. As compared with the analysis of the preceding chapter, the distinction between the certainty and the uncertainty models is less marked here, although much of the discussion there can be applied again and need not be repeated. The central point is that distributional considerations which might influence the selection among tax instruments tend to be reduced in importance as genuine uncertainty increases at the moment of fiscal choice. If the individual is uncertain as to his own income prospects over time, and also as to his own basic expenditure desires, he may accept that there are certain criteria which will, roughly and approximately, measure his unadjusted marginal utility of spending in future time periods. He may say something like the following: “If either my income is high enough or my essential spending desires low enough, I shall probably find myself purchasing a boat or a custom-tailored suit and my wife a mink cape. Such items seem now to me to be reasonably good independent measures of the marginal utility of income. Hence, if a tax is laid on the purchase of such items, I can maintain some insurance against being subjected to burdensome tax pressure when my needs for basic goods and services are unexpectedly high or my income is unexpectedly low.” In one sense, the choice of the excise on residual and postponable items of consumption spending reflects the same sort of mental calculus that might support a decision to exempt certain basic consumption spending from income tax (more on this below).
In the uncertainty model, we need make no particular assumption about the workings of the capital market. With future income receipts as well as spending plans uncertain, the whole conception of an “optimal” or “equilibrium” pattern of spending over time loses much of its meaning. The individual will, more or less as a natural order of events, expect the marginal utility of his expenditure dollar to vary as among periods. If he could, with some certainty, map out a preferred stream of spending, he might find that attainable resort to the capital market would eliminate any possible differential advantage of the specific excise tax. If uncertainty exists beyond some degree, however, he may find such resort to the capital market impossible.
The individual has been assumed to be motivated by straightforward utility-maximizing considerations. A somewhat broader conception of choice allows for a more complex preference function. The first additional element involves the subjective or “felt” burden of tax payments in future time periods. At the moment of constitutional-institutional choice among tax instruments, the individual may be influenced by his predictions about his own reactions, in later periods, to the institution that is selected. He may realize, for example, that on each tax payment date, the income tax will impose on him a genuine “felt” burden. On the other hand, he may also recognize that, since he pays the tax along with the price of a specific commodity, such a burden may be absent under the commodity tax. This is a fiscal illusion, and the individual in his more rational moments may recognize that he will be subject to it. But he may, deliberately, choose to impose the future taxes upon himself in such a way as to minimize subsequent subjective burdens of payment. Or, conversely, he may recognize that the presence of illusion will cause him to act unwisely in operational fiscal choices concerned with the extension of public activities. And, for this reason, he may choose to reject the excise-tax alternative.
A second possible complexity in the individual’;s preference function involves his attitude toward his consumption of the residual items. He may recognize that, on occasion, he is the slave of his passions, and because of this, he may choose to place obstacles on his own behavior. Sumptuary taxation can be derived from an individual calculus of choice. Nevertheless, care must be taken to distinguish this attitude from the paternalist or dirigiste one, through which the individual attempts to lay down standards of conduct, not for himself, but for others in the social group (more on this point below).
Problems of Aggregation
Individuals are not, of course, allowed to choose separately and independently the fiscal instruments through which their financial obligations will be met. As in the earlier analysis of the progressive tax, it is necessary to shift from isolated individual choice to individual participation in group choice. The collectivity must select the tax instrument which will, when chosen, be imposed on all members of the community.
The consistency of individual decisions or preferences, one with the other, must be examined. While it may be rational for the isolated person to prefer a privately levied tax on a specific commodity, he may not want the collectivity to impose such an indirect tax. There may exist no substantial agreement on a single commodity or service to be taxed. What one man may think of as a “luxury” good, and its purchase a reasonably good independent criterion for the marginal utility of his own spending, a second man may consider to be a basic and essential item, necessary to life, happiness, and well-being. If wide divergencies of this sort exist, the individual participant in group choice may well abandon any support for excise taxation. On the other hand, members of most political communities are culturally homogeneous to some degree. This suggests that substantial, if not total, agreement may be attainable on a relatively small set of specific commodities that might be subjected to excise levies. To the extent that the required homogeneity holds, indirect taxation may emerge from the group decision process, in which individual attitudes and choices are based, at least in part, on the sort of considerations that have been discussed here. One person, participating in group choice, may estimate his own future consumption purchases of champagne to be a good measure of his relative “welfare” in future periods of time. A second may consider his wife’;s purchases of perfume a somewhat better indicator. After discussion, argument, and compromise the whole group may agree that a relatively small bundle of commodities, including champagne and perfume, provides a reasonably good index for the marginal utility of future spending for each man.
Elements of paternalism cannot, of course, be eliminated from a collective choice among tax instruments. Each participant in a collective decision, be he voter, political leader, or bureaucrat, has a set of preferences, of “values” not only for himself but also regarding the behavior of others in the community. And since the outcome to be chosen must apply to all members of the group, there is no way that the individual participant can be limited to basing his choices on the considerations of his own future behavior pattern. The point to be stressed here is not the absence of parternalist elements in choice; instead, the emphasis should be on the fact that such elements need not be present to derive individual, and through these, group preferences for specific commodity taxation. Alcohol may be taxed heavily in most jurisdictions because voters and political leaders think that their fellow citizens “should” be discouraged from drinking. But, also, alcohol taxes may be accepted because the potential taxpayer, himself, knows that he can escape taxation by refraining from drink. In some basic, philosophical sense, indirect taxation of specific commodities allows the potential taxpayer more ultimate choice than direct taxation precisely because it is specific. He retains an additional faculty of choice over time, so to speak, because he has available a wider range of alternatives than he would retain under direct taxation. This faculty may never be exploited; indeed, the individual will hope that he will never find it necessary to reduce his net tax payment to zero in any period. But the existence of this wider range of potential choice may be decisive in certain circumstances.
This chapter has not been aimed at providing a normative “defense” of specific excise taxation. The analysis has shown that there exist certain conditions under which such taxation becomes “efficient” for the rational individual taxpayer. The results may be generalized to a community of individuals only if there exists reasonable consensus on a set of commodities or services, the purchases of which provide a criterion for the marginal utility of spending in different periods of time.
At one point the similarity between the imposition of specific levies on items of residual consumption and the exemption of certain items of basic expenditure from the income-tax base was noted. It will be useful to examine these two fiscal devices more carefully, since both are to be found in modern fiscal structures. Both schemes may have been introduced, and supported, at least in part, to include some recognition of fluctuating needs for basic consumption over time, and the relevance of this for defining the tax base. The exemption or deduction of such items as medical care and education from the tax base involves the acknowledgment that, during periods when expenses on these are high, income alone does not provide an adequate criterion for computing tax liabilities. Outlays for residual consumption items provide another set of independent criteria, at the “other end” of the consumption spectrum, so to speak. In either case, the taxpayer retains a somewhat greater freedom of action than he would retain under the general income tax without exemptions. The freedom of the taxpayer to adjust his own liability through a modified pattern of consumption spending is present in both cases, but there is a difference. Under the deduction scheme, the taxpayer can reduce his liability for income tax only by purchasing the specific items, say, medical services or education. Under the specific excise tax, he can reduce his fiscal liability by reducing his purchases of one or a few items, leaving him a broader range of alternatives on which to spend.
One of the interesting by-products of the analysis is the relatively low ranking that emerges for the general consumption or expenditure tax, which adjusts individual tax liabilities to total spending in each period.10 The case that has been made out for specific excise taxation depends, strictly, on the specificity of the objects taxed. On the basis of an individual choice calculus, it is difficult to see how an argument for general spendings taxation could be derived. The familiar distortion in static spending patterns is, of course, smaller under the general tax than under the specific levies. However, static or in-period distortion can always be minimized with direct taxes on income which are also preferred on the temporal distortion scale.
The Institution of Public Debt
When should governments borrow rather than tax? This is a classic question in the theory of public finance, along with those discussed in the two preceding chapters. Can the institutional-choice approach to fiscal systems be applied to this question?
We are concerned with public debt as a fiscal institution through which a collectivity may finance public goods and services and with the individual’;s evaluation of this institution. Governments borrow as an alternative to taxing, and it is appropriate to consider borrowing as an addition to the revenue-raising alternatives listed at the beginning of Chapter 16. Are there any conditions that may cause the utility-maximizing individual to select, at the moment of constitutional-institutional choice, the public loan over any of the tax alternatives? Recall the characteristics of the situation that we have presumed to confront the individual with at this moment of choice. He is not choosing between debt issue and taxation for the financing of a specific public good or service in a specific time period. The individual recognizes that the fiscal instrument to be chosen will remain in force over a whole series of time periods, and that it will be employed to raise funds for a stream of public goods and services, with the precise nature, the range, and the extent of these goods and services to be determined from period to period, and with the benefits from this stream of services wholly unpredictable at the moment when the revenue-raising institution is to be selected. It is in this situation that we ask the question: Will the individual find it desirable for the collectivity to resort to debt issue?
It will be helpful to employ the same device that was introduced in Chapter 15. Assume that a given individual is assigned a specific share in some aggregate community liability and that he is able to define this share in terms of a definite present value at the moment of constitutional-institutional choice. For simplicity, we shall say that this present-value liability is set at $1000. This liability must be recognized as such under any of the institutional alternatives that the individual confronts. Hence, the public debt instrument, as one of these alternatives, must be defined in such a way that the individual is required to meet the obligation over a time span that is within his own planning horizon. That is to say, public debt must be considered for periods of sufficiently short maturity to insure that the individual making the choice shall recognize that he must amortize his own share in the community liability during his own planning period. If this constraint is not imposed, there would be no way of making a present-value liability under debt equivalent to those under various tax institutions. Therefore, we shall simply postulate here that the debt will, if issued, be amortized over a period of, say, ten years. In this restricted model, the individual can, through his community’;s resort to public debt, postpone current payment for public services for a maximum of ten years. The question becomes: Are there conditions under which he would wish to select the institution which facilitates such a postponement? Will he prefer that the government issue bonds as a means of raising revenue to finance public services for each of the first nine years? Or, will he choose to have his government rely on one or several of the standard tax instruments?
As in some of the previous models, it will be helpful to assume initially that the individual knows with certainty the pattern of his income receipts and his private spending over the relevant time period. It is not necessary to specify any particular pattern of either of these streams. When we allow the public debt alternative to be considered, we reach quickly what appears to be an unorthodox or startling conclusion. Given such an opportunity as that posed, the rational individual will always choose that all public goods and services be financed through public debt issue. This result seems striking at first glance, and it seems to be so much at odds with accepted principles of fiscal practice that one searches for the fallacy that must be hidden somewhere.1
There is, however, no such fallacy lurking in the underbrush, and within the limits of the model examined here the conclusion holds. Why should the individual select the debt alternative? He will do so because this alternative is the only one that allows him full freedom of choice in adjusting his income-spending pattern over time. Public debt, as an institution, effectively allows the individual to meet his assigned liability “optimally,” and it is the only revenue-raising alternative that accomplishes this, given the operation of a capital market that requires private borrowers to pay something over the government borrowing rate. As the collectivity borrows to finance currently supplied public goods and services in each period, the individual is placed in the position of borrowing, one stage removed, at the government rate. In effect, through issuing debt, the government is borrowing for the individual. If, therefore, the individual’;s pattern of net income receipts or spending over time is such that he desires to postpone meeting his fiscal obligation, the public debt alternative enables him to do this at no net cost. On the other hand, if his pattern of income-spending flows is such that he chooses to discharge his obligation early during the time sequence, he can always do so by purchasing government securities and holding these until the time of debt retirement-taxation, when his accumulated assets will just offset his accumulated tax obligations. In effect, the public debt allows the individual both to borrow and to lend at government rates, and hence to remove any temporal distortion from his spending pattern.2
The analysis suggests that the isolated individual should rationally select public debt as the means for financing public goods and services. Why has this alternative not commanded more respect in the institutional structure of real-world fiscal systems? The underlying assumptions of the model require more careful consideration.
The individual’;s share in the aggregate community liability has been assumed to be preassigned in some present-value sense, at least insofar as this informs his own choices. But can such a share really be assigned in advance? The difficulties that arise here are not the same as those we have discussed previously in the analysis of progressive income taxation. The difficulties here stem from what we may call the “contingent liability” that public debt must embody under normal political circumstances.
Let us assume, as before, that, provisionally, some share in an aggregate community liability has been assigned to the reference person, and that similar shares have been parceled out to all members of the political group. Next, assume that no distributional problems explicitly arise here; the individual proceeds as if he will fully meet his own assigned share over the period in his own optimally selected manner. On the basis of some such calculation as that outlined above, he opts for the debt alternative; others in the group agree, and all public services are initially financed by public loans. The reference person then carries out his plans as projected, meeting his fiscal obligation as these plans dictate.
Now suppose that the final accounting period arrives; all issues of debt must be retired. The individual in question has accumulated, through his purchases of bonds over the period, sufficient assets to meet precisely the share of the liability during the final period that his plans dictated. All seems well; he seems to have chosen the ideal fiscal arrangement.
All is not well; and herein lies the rub. Suppose that a second person, Mr. B, likewise made optimal spending plans when the time sequence commenced and the fiscal alternative was selected. However, suppose that B has failed, over time, to live up to such plans as he had initially laid down. The final period arrives, and he has not accumulated sufficient assets to offset the meeting of his fiscal obligation. He simply cannot “pay off debt” or “pay taxes” in this final period and discharge his assigned multiperiod liability. This failure of B to live up to his rationally projected plans need not bother our first person, A, except to the extent that he understands that B’;s plight imposes a clear contingent liability on him. The funds have all been spent in the separate periods in financing the public goods and services. The aggregate liability for the whole collectivity must be paid, assuming that the community does not choose to default on its loan. B has, however, behaved either irrationally or irresponsibly over the period and he cannot meet the share that he implicitly agreed to meet. Consequently, it falls to the remaining members of the political group to bear the liability that was initially assigned to B. Others will find themselves paying for B’;s profligacy or deceit.
Note that A himself, the individual whose calculus of choice we are considering, will behave here precisely in accordance with his plans. He will, nonetheless, be unduly burdened at the end of the period to the extent that B’;s behavior runs contrary to B’;s projected plans at the start of the time sequence. The reference person, A, will tend to recognize this contingent liability aspect that the public debt instrument may embody. When he does so, he will tend to reject the debt alternative, and to select instead a tax institution, despite the acknowledged superiority of debt in terms of efficiency criteria in an isolated individual income-spending pattern.
No irrationality has been introduced in the analysis here. The reference individual need not fear for his own ability to meet targets that he lays down at the time of institutional choice. He will tend to reject the generalized usage of public credit not because he fears that he cannot live up to the model of behavior that he sets himself, but, instead, because he fears that some among his fellow citizens may fail to live up to their own targets of behavior. The acceptability of public debt requires, then, that the individual not only predict his own rational behavior, but, also, that he can predict with reasonable certainty that all other members of the group, or at least a sufficient portion of them, will likewise behave rationally and responsibly. This requirement becomes extremely restrictive and seems likely, in most cases, to rule out general approval of the debt alternative.
Why do these same fears concerning the rational and responsible behavior of other persons not arise in the considerations among the various tax alternatives? The analysis of the preceding chapters has shown that the efficiency advantages of both progressive income taxation and specific commodity taxation may stem from the fact that these institutions allow the individual to shift his fiscal liability through time in such a way as to reduce temporal distortions in his spending pattern. Why will not irrational or irresponsible behavior on the part of others than himself here too affect the individual’;s own liability?
The essential difference between these tax institutions and that of public debt stems from the fact that, under any tax institution that allows for fluctuations in individual liability over time, separate persons in the group tend to offset each other. Periods when one person’;s income is relatively low, or private spending relatively high, may be periods when another person’;s income is relatively high, or private spending relatively low. If the individual assumes that over-all income and spending in the economy will remain roughly stable or rise steadily, this result is assured. Public debt, by contrast, involves no such offsetting through the fiscal structure. All public goods and services are financed by debt in the initial periods (in the general model considered here). Fiscal bills pile up; no one is required currently to pay for the stream of public services. Current-period adjustments, if they occur, must take place within the private accounting systems of individual citizens. The fact that rationally behaving individuals may be acting in accordance with optimal plans is not externally revealed to the observer, nor is this behavior required in any way.
The reference individual may, of course, also harbor some doubts about his own rationality in following out some predetermined plan of spending-saving. To the extent that he does so, he will reject the debt alternative, quite apart from the contingent liability effects here emphasized.
The above analysis demonstrates that even if the individual knows with certainty his income prospects and his private spending plans over the relevant time span, and even if he is confident that he can carry out some predetermined plan of behavior, he may still reject the public debt as his most preferred general financing institution because he cannot predict that others will behave responsibly and rationally. As we have done in previous chapters, the unreal assumptions as to certain prospects must now be relaxed. Assume now that the reference individual’;s income prospects and/or private spending needs are uncertain and subject to some fluctuations over time. How will this change the conclusions about his attitudes toward the debt institution?
It is best to examine the individual’;s choice calculus on the assumption that total income in the whole community remains uniform over time or grows at some predictable rate. This allows us to concentrate on fluctuations in individual income receipts or in private spending needs independently of over-all aggregate fluctuations. As suggested earlier, with uncertainty as to receipts or outlays over time, the very notion of some optimally planned pattern of spending through time scarcely exists. The individual’;s decisions will be informed largely by current or in-period comparisons of income receipts and outlays. He should be able, however, to distinguish among periods of relative affluence and relative penury, not necessarily in advance but as events materialize. In the former, he will tend to put aside some income as savings to protect his economic position contingently over possibly lean periods. In the latter, he will tend to resort to the loan market, either borrowing from himself out of accumulated savings or externally from others. Previous chapters have demonstrated how the progressive income tax on the one hand and specific commodity taxation on the other may allow the fiscal structure to facilitate the individual’;s temporal adjustments. The question here is whether or not public debt can accomplish similar purposes?
The answer is negative. Public debt does not provide a means of bunching fiscal liability during periods of relative affluence comparable with the other two institutions discussed. For the whole group, public debt allows for a postponing of fiscal liability through time, but in the final accounting period, when debt must be retired, some taxpayers will be affluent, some will be penurious. Not knowing to which group he may belong, our reference individual will rationally reject the debt alternative as the general financing instrument. Public debt allows such a bunching in time only in the certainty model, and only in a highly restricted form of this.
In the real world some mixture of the certainty and the uncertainty models normally is descriptive. The individual can make some reasonable predictions as to his income prospects, and he can project within limits his needs for private spending over time. There is some sense in his attempts to frame optimal saving-spending plans. The important barrier that prevents his selecting resort to public credit as the general financing device lies in the contingent liability aspect discussed with respect to the certainty model above.
Public Debt and Individual Planning Horizons
In all of the models discussed to this point, the individual has been assumed to evaluate public debt as a means of financing general public goods and services. As compared with its alternatives, debt issue has been assumed to impose comparable liabilities, computed on some present-value basis, on the individual who is making the choice among the fiscal institutions. If human beings should live eternal lives, no problem need arise. But since they do not, it was necessary to postulate that debt must be issued in such a way that amortization occurs within the planning horizon, the life span, of the individual decision-maker. If this restriction is not placed on the models, there is no way in which public debt can be made genuinely comparable, in our terms of reference, with tax alternatives except through some quite arbitrary assumptions about human behavior. If individuals, despite the limitations on human life, treat their heirs as lineal extensions of their own lives, which was the assumption always made by Ricardo, no problem arises. In this case, individuals act as if they live forever. But individuals may not behave in such a fashion, and if they do not, public debt, which allows them to postpone fiscal liability, may provide a means of redistributing the net fiscal load intertemporally. If, at the time of constitutional-institutional choice, the individual considers public debt as a means of shifting the final fiscal liability forward in time to “future generations,” he will, of course, tend to select this instrument on the basis of utility-maximizing considerations.3
The rejection of the debt alternative in this limited-time-horizon situation must be based on the individual’;s acceptance of some ethical principle of intergeneration equity. If he makes plans on the basis of a limited time horizon and does not fully incorporate the interests of his descendents in his own, the individual will tend to select debt as the means of financing public goods and services unless he is deterred by some such ethical norm. Of course, if general acceptance of debt issue should become widespread, reflecting an absence of the effectiveness of this norm, the likelihood that future generations would, in fact, default on inherited debt obligations would quickly become an economic deterrent to this institution. For these and other reasons, it is appropriate that the analysis here be restricted to the model where debt is amortized within the planning horizons of the decision-makers.
The Public Debt Illusion and Its Converse
To this point the analysis has been limited to an evaluation of public debt as a general source for raising governmental revenues. It has been argued that the individual’;s probable rejection of this alternative stems, at least in large part, from his distrust of fellow taxpayers’; ability or willingness to carry out optimal spending-saving plans. One element of this mistrust may arise out of the recognition that public debt may generate a fiscal illusion. Although fiscal liabilities are created at the moment that debt is issued, individuals may not act as if such liabilities exist. They may not fully capitalize the future taxes that the debt must embody, in service and amortization charges, and if they do not, they will not behave rationally in making plans to discharge their own shares in such aggregate liability.
The debt illusion has its converse, however, and when this is also recognized, public debt again assumes a limited but legitimate place in the acceptable array of fiscal instruments. To this point, as noted, revenue-raising alternatives, including debt, have been considered a means of raising general revenues for the financing of all public goods and services. Although the assumption was not explicitly made, the results derived are wholly appropriate only if the benefits from the provision of public goods are concentrated during the periods when the public outlays are actually made. This does not characterize all public outlay; some takes the form of capital investment which yields benefits over a whole series of time periods.
Let us now examine this sort of public outlay independently. Assume that the individual is faced with selecting the appropriate fiscal instrument or institution for financing only quasi-permanent public goods, the benefits from which will be fully realized only over the long run. As in the more general model, we assume that the individual does not know precisely the pattern of these capital projects, and he has no way of predicting whether or not he will personally benefit from such projects in particular periods of time. His task is that of selecting the fiscal means of financing public capital projects, and these only, with the actual decisions on the form and extent of these projects to be made in subsequent periods.
Here the choosing person may recognize that the temporal distortion between the receipt of benefits from public capital projects and the impact of the payment institution may tend to bias in-period decisions against such outlays under the standard taxing instruments. In other words, for projects that involve benefits which accrue over time, there may exist some “asset illusion.” The individual may not fully capitalize the future benefits that such quasi-permanent outlays will yield. If he does not, he will not make “proper” decisions concerning the amount of taxes to be levied or the “proper” allocation of funds within a limited revenue budget. Budgetary decisions will tend to be biased in favor of short-term and against long-term public projects.
If the individual, at the level of institutional choice, recognizes that this sort of illusion is likely to occur, he may prefer that public debt be authorized as the revenue-raising device for such projects. Here, the individual who makes in-period operational budgetary choices may suffer both a public debt illusion and an asset illusion. He may fail to capitalize both the liability that the debt side embodies and the benefit stream that the asset embodies. But these two illusions become offsetting here, and the individual may predict that more rational in-period budgetary choices will emerge under such a structure than under one that is limited to tax financing for all outlays.
Note also that if it is limited to financing only capital projects, the public debt alternative need not involve the contingent liability element to the same extent as the more general model. Operating under the debt illusion, individuals may not make adequate plans to meet fiscal liabilities when these are due. However, insofar as the projects financed are genuinely chosen so as to yield benefits over time, presumably the ability of individuals to meet postponed liabilities is enhanced by these public service benefits, which are, in one sense, translatable into real incomes. The contingent liability element cannot be wholly eliminated, even for debt issue limited to the financing of long-term capital projects, because the accrual of benefits need not be distributionally equivalent to the optimally projected allocation of fiscal liabilities. It should perhaps also be noted that the ethical principle against the issue of debt which embodies some transfer of net fiscal liability to future generations of taxpayers does not fully apply when debt is limited to financing genuinely long-term projects. In this case, future generations enjoy the benefits as well as inherit the liability.
The analysis suggests, therefore, that public debt issue may be chosen as an appropriate part of the over-all “constitution” of a fiscal structure, provided that limitations are imposed to insure that debt financing be restricted to projects that yield benefits over time. “Capital budgeting” can be rationalized on the basis of the individual decision calculus here introduced. These conclusions are similar to those that were developed in the traditional or classical theory of public debt, and they have been incorporated into responsible fiscal practice. This correspondence itself, along with other instances noted in this book, tends to corroborate the efficacy of the general approach adopted.
Fiscal Policy Constitutionally Considered
To this point, all problems concerning the possible utilization of fiscal instruments to accomplish macro-economic objectives have been deliberately neglected. Any claim that the approach is a general one must include some reference to its ability to handle these problems. Can a normative “theory of fiscal policy” be derived from an individual choice calculus? Will an individual, at the moment when he is confronted with defining a fiscal constitution, authorize his government to employ the budget as a stabilizing, growth-inducing instrument?
Will an individual prefer that the aggregate income of the community in which he lives rise at some steady rate (or remain stable) or that it fluctuate around some long-term growth path? If he can predict his own income prospects with certainty, he need not be directly concerned with fluctuations in aggregate community income, although he may be indirectly concerned through tax-base externality. He will, however, be directly interested in aggregate income growth if his own income prospects are expected to correspond with those of the community in general. Here he will clearly prefer steady growth to unpredictable fluctuations. He may also prefer income stability to wholly predictable fluctuations if resort to the capital market is costly and private spending needs are relatively more stable than income. As the analysis of Chapter 15 indicated, the individual should select tax instruments which will mitigate the impact of his own fluctuating income prospects. Tax institutions that contain significant built-in revenue flexibility will tend to be selected. If, however, fluctuations in personal incomes are general over the whole community and not offsetting among separate persons and groups, the built-in flexibility of the tax structure will cause revenues of the government to decline sharply during periods of cyclical downswing. More appropriately stated, if aggregate community income does not grow at its average rate, governmental revenues will fall short of their projected levels, even if they do not decline absolutely. If the rule of in-period budget-balance is strictly enforced, public services supply will be curtailed during such periods, and, of course, expanded sharply during booms, neglecting possible in-period tax-rate adjustments.
The question is whether or not the individual will choose to allow specific relaxation of the rule of in-period budget-balance in order to facilitate a steadier flow of public service supply over time. It seems evident that he will do so. Note, however, that this departure from in-period balance is justified solely on the grounds that it will facilitate a smoothing out of public spending over time. We have not yet examined the individual’;s choice calculus when he recognizes that, by allowing some departure from in-period budgetary-balance, aggregate community income over time may actually be increased. Fluctuations may not take place around some long-term growth path, but, instead, may represent a “bouncing down” on occasion from a long-term growth path considered properly as a ceiling. It is this latter purpose of unbalanced budgets that the Keynesian and post-Keynesian discussion of fiscal policy is all about. It also seems clear that the individual, who is presumed here to be contemplating the design or constitution of the financial structure of his government, will tend to prefer features for this structure that will promise the highest level of community real income over time, other things equal. His motivation is found directly in the fact that his own income prospects are related, probabilistically, to aggregate community income.
Fiscal Policy in a Closed National Economy
The next question is that of determining what structural features of a budgetary policy will best accomplish this. It is necessary to make additional clarifying assumptions at this point. Assume that the individual, whose constitutional choice process we are examining, lives in an isolated, fully closed economy, with only one governmental unit. Fluctuations in aggregate money income are anticipated to occur because of changes in the demand for circulating media, and these are expected to be translated quickly into fluctuations in real income and employment on the downside because of acknowledged rigidities in the wage-price structure. Assume further that the supply of money is not directly controlled by the government, despite its money-creating powers, but is, instead, allowed to adjust passively to demands via the mechanism of a banking system. The government may, however, add directly to or subtract from the supply of money by an exercise of its money-creating power.
In such conditions as these, the rational individual should recognize that the government’;s budget provides one instrument that might be utilized directly to insure against downswings in community income. Some departure from the strict rule of in-period budget-balance is suggested, despite the effects of in-period fiscal choice that this departure might also be predicted to produce. (These effects have been discussed in Chapter 8.) The individual may, therefore, authorize or “vote for” the authorization for the government to create deficits deliberately during periods of threatened retardation in aggregate community income growth. In these conditions, deficit creation may be among the set of fiscal institutions judged to be efficient by the individual citizen.
Deficits, if they are allowed to occur, must be financed, and the mere authorization of deficit creation does not imply anything at all about the manner of financing them. Nevertheless, the rational response of the individual here seems clear. He will authorize the government to create money in order to cover deficits in its current budget accounts during periods of real income slack. Money creation by government along with the injection of the newly created money into the economy via the fiscal process seems indicated. If the deficit-creating, deficit-financing institutions are successful in accomplishing the objective sought, community income will grow at a steady rate.1 This growth in itself will require that net additions be made to aggregate purchasing power over time if final product prices are to remain stable; hence, a net budget deficit over time becomes desirable.2
Note that nothing in the analysis here suggests that public debt issue be authorized as a means of financing budget deficits. Public debt is a different fiscal institution from money, despite the unexplainable and near-inconceivable refusal of many sophisticated economists to recognize the distinction. By definition, an issue of public debt must involve a transfer of current purchasing power (liquidity) from the lender (a member of the public who purchases the securities) to the borrower (the government) in exchange for which the borrower obligates itself to pay an interest charge during subsequent time periods. An operation of this sort is obviously undesirable when the purpose of the budget deficit is to increase the total flow of spending in the economy. Hence, the rationally chosen institutional structure will contain no provision that would allow the financing of budget deficits by debt issue, under the conditions postulated.
Fiscal Policy in a Wholly Open Economy: The Case of the Local Governmental Unit
The conclusions reached above hold only in the wholly closed economy. To the extent that an economy is open, different conditions prevail and the whole analysis requires re-examination. By an “open economy” here we mean that citizens are free to purchase and to sell goods and services with citizens of other jurisdictions, and, beyond this, are free to transfer both labor and capital resources freely among separate jurisdictions. Real-world national economies normally represent some combination of the closed and open models. We shall return to discuss these mixed models at a later point. The extreme example of an open economy is that of the local community in a larger national economy. Here not only does freedom of trade and of resource mobility exist; also, the local governmental unit does not normally possess the constitutional power to create money. It will be helpful to examine the individual’;s choice process when he attempts to select an optimal fiscal constitution for the local governmental unit. Will he find it desirable to include institutions that will produce a positive fiscal policy for the local governmental unit? Will provisions be made for allowing budget deficits to be created and financed during periods when the state or the municipality is characterized by relatively low levels of aggregate income?
Somewhat surprisingly, this question seems rarely to have been raised. There has been considerable discussion concerning the role of state-local governments in macro-economic policy.3 This discussion has been concentrated on measuring the actual impact of state-local fiscal structures on the flow of national spending over past periods. There has been almost no discussion of the normative principles which “should” guide state-local decision-makers. Inferentially, the textbook or standard attitude seems to have been as follows: It would be desirable if state-local units should “co-operate” with the national government in furthering the “national interest” by explicitly adopting counter-cyclical policies. Few scholars have asked the question: What should state-local units do in this respect in furtherance of their own interests?4 To rephrase this same question so that it fits our own frame of reference: Will the individual want to include in the fiscal constitution of his local governmental unit some provisions for a positive fiscal policy?
The answer is not so simple here as that derived with respect to the closed economy; the institutions available to the chooser are different in the two cases. For the local government, the financing of budget deficits must involve borrowing, the creation of public debt. The unit has no recourse to money creation. The fiscal structure that was shown to be optimal for the closed national economy cannot, therefore, be applied for the local unit. Will a policy of deficit creation, with deficits to be financed by debt issue, prove efficient?
Consider once again the setting in which this question is put. The individual anticipates that the income of the local community may fluctuate over time, and that his own income prospects are directly related to the levels of community income, although somewhat less so than in the previous model. If his needs for both private and public goods are expected to be more uniform over time than this income, he will tend to approve both tax devices that contain some built-in revenue flexibility and also some authorization for public debt issue. These institutions combined will facilitate a smoothing out of both private and public consumption over time.
This does not, however, get at the central question. Will a positive fiscal policy—that is to say, one that is designed to raise income levels of the community during periods of depression—seem desirable as an adjunct of local government fiscal structures? To get at this, we must inquire concerning the predicted effects of deficit creation and deficit financing in periods of locally depressed activity. Aggregate income in the community is presumed to have fallen. A budget deficit has emerged as revenues from approved tax institutions have shrunk and as spending rates have been maintained or increased. To finance the deficit, the local governmental unit has created and sold public debt instruments on the capital market. Can this combination of events be expected to generate a real income increase in the local community? The answer is clearly affirmative, and for a reason that may appear paradoxical to some scholars. The flow of spending in the local community will increase because the government here borrows funds on the national capital market. If this unit is small relative to the size of the total economy, the interest rate is not modified. The debt created is external to the local community; no funds are drawn away from either local consumption or investment spending. If, through some quirk, funds have been drawn from local sources, that is, if the debt is internal, there would be little, if any, income-creating effects of the combined operation. This seems almost to reverse the implied conclusions of much orthodox theory; the elementary textbook discussion of fiscal policy is likely to suggest or to infer that deficit financing is to be recommended as income-generating only if internal public debt is used as the financing device. By contrast, the model here suggests that deficit financing through public debt issue is efficient only to the extent that external debt is created.5
The combined operation tends to attract capital funds from the whole economy; these funds are expended locally by the governmental unit in purchasing public goods and services. Aggregate community income rises; unemployment is reduced. Real income of the local community over time is increased. A heritage of public debt will exist after the initial period, and this will impose a net burden of servicing this debt on taxpayers in all subsequent periods. The question becomes that of determining whether or not the current-period increase in income is sufficient to outweigh in present value the discounted value of the future tax obligations.
Consider first an extreme case in which the local community purchases the public goods supplied to local citizens exclusively from external sources. Pure examples of this sort are difficult to imagine, but one could think of a local community supplying educational services to its children by sending them bodily to other communities for schooling, paying the other communities for these services. In this case, there would be no local income multiplier effect. However, since the public services themselves represent additions to real income, the combined operation is still desirable, provided only that the decision to supply the services is an efficient one. The present value of future taxes required to service the debt that financed the services should just be equal, in some objectively quantifiable sense, to the current value of the services that are supplied. But, of course, the combined operation here would do nothing to increase local income and employment outside the particular benefit stream.
In almost all cases, there will be a local multiplier effect. The community will only in rare circumstances purchase resource inputs exclusively from external sources. Normally, in supplying local public goods and services local citizens will be employed, local inputs will be purchased. To the extent that this takes place, some of the debt-financed spending by the local government will remain in the community and private spending in subsequent periods will increase. When this occurs, the combined deficit creation-debt financing operation will clearly be extramarginal. The present value of the future taxes required to service the debt obligation may fall far short of the current value of the public service benefits plus the current net additions to local income. A positive fiscal policy seems clearly to be desirable for the local governmental unit when its operations are viewed ex ante, even though this unit does not possess money-creating powers.
To this point, we have assumed that income in the local community declines without specifying what happens elsewhere in the national economy. It is perhaps evident that the analysis above holds without reservation in those situations where national aggregate income remains constant or increases at some steady rate while local community incomes vary. Suppose, however, that the over-all level of national income falls below desired levels uniformly in all areas of the economy. Will it then be desirable for a single local governmental unit to follow a positive fiscal policy? If the national government takes no action of its own to bring over-all national income to desired levels, there is no basis upon which a single local unit can predict the trend or growth path of national income over time. Faced with depression in its own area that is known to be matched by similar conditions elsewhere, should the local unit carry out fiscal policy?
Suppose that the central government adheres strictly to a rule of in-period budget-balance, and that it undertakes no positive monetary policy. Income throughout the economy falls as a result of hoarding, and this affects all local communities uniformly. Consider then the plight of the single local government. Assume that no other community is observed to undertake fiscal policy action. What will happen if the one local unit, on its own, tries to carry out positive fiscal policy? Income in the community is below desired levels; and revenues from existing tax institutions are below those needed to finance public spending. In order to maintain public-goods supplies, the local unit issues public debt. This debt will be purchased and the funds supplied by the banking system at existing rates of interest. The local community’;s behavior here adds a net increment to the spending stream in the economy, and, for the national economy as a whole, the full income multiplier will operate. But, for the local unit, leakages to other communities can be predicted. However, some local multiplier effect will remain, as suggested above. The fiscal policy action remains rational within certain limits.
As income in the single community rises, resources from external sources will tend to flow differentially to the area, quite apart from the ordinary leakages. These resources will compete with local resources for employment, and an unduly high level of unemployment may remain. Should the community, still acting alone, continue to add to its spending rate through deficit creation financed by debt? Beyond some point, there will be little current real income to be gained from expanding local public-goods supply. However, if local income gains are sufficient, continued deficit creation is suggested, provided only that the resources which flow into the local area are somehow brought into the local tax base. In other words, if the local income generated as a result of the operation can be made the base for future tax obligations embodied in the debt that is issued, there is no reason why the single local community should not continue to carry out the fiscal policy so long as net increments to local income exceed the current value of future taxes made necessary by servicing and amortizing the debt.
Fiscal Policy for the Private Citizen
If the analysis of normative fiscal policy for the single governmental unit in a wholly open economy is accepted, similar conclusions should follow for the individual since his “economy” is, par excellence, wholly open. In making his earning-saving-spending plans over time, should the single person or family act so as to conduct “positive fiscal policy”?
It seems evident that he should do so. If his own income declines while the income of the whole community remains steady, he should, of course, borrow in order to stabilize spending. If this borrowing-spending generates any “private multiplier” effects on his own income, this provides an extramarginal incentive for such behavior. The difference between the individual and the local government arises solely out of the fact that the latter, being the larger, is more likely to enjoy some local multiplier effects. The point to be emphasized here is that, conceptually, there is no difference at all in the principles of rational behavior. The individual who lays out his own optimal spending-saving plans over time, and the individual who tries to lay down, constitutionally, the optimal spending-saving plans for his local governmental unit are one and the same, and behavior in each case is informed by the same criteria.
Fiscal Policy for a National Government in a Partially Open Economy
National governments possess money-creating power. This essentially distinguishes them from local governments. But they may operate in an international economic order that is substantially open, especially in that trade can move freely across national boundaries and that capital is highly mobile as among different nations. The model to be used in deriving a logic of fiscal policy from individual choices here must be some combination of the wholly closed and the wholly open economy models that have been examined above.
Since national governments do possess powers of money creation, some assumptions must be made concerning the institutions that relate national currencies one to the other. It will be helpful to consider the models under each of two assumptions, freely fluctuating exchange rates and fixed exchange rates.
National Fiscal Policy Under Fixed Exchange Rates in an Open International Economic Order. In specifying the conditions of this model, we may follow Mundell in assuming that the mobility of capital is such that interest rates among separate countries tend to be equalized.6 Let us also assume that the country is small relative to the world economy.
Suppose now that a decline in the level of spending in the national economy is anticipated. Assume that the standard Keynesian conditions are present. Wages, and prices, are rigid against downward pressures. It will be useful to trace the effects of three possible sets of governmental actions designed to prevent the decline in national real income.
1. The government may create a budget deficit (or allow one to emerge) and finance this deficit with the creation of new money. Aggregate spending is maintained at the desired level. Interest rates do not move upward or downward; hence, there is no net change in international capital flows. Prices remain steady; there is no change in the international balance of payments. It seems clear that this set of policy instruments, which is the same as those previously shown to be efficient for the wholly closed economy, remains the efficient set under this partially open model.
2. The government may attempt to accomplish the same purposes through orthodox “monetary policy,” defined as the use of open-market weapons. In an attempt to stimulate internal demand, the monetary authority purchases securities. Interest rates will tend to fall; capital flows out of the country. A balance-of-payments deficit emerges, and the monetary authority may find it necessary to sell foreign exchange to restore this balance. This, in turn, offsets the initial purchase of domestic securities. Monetary policy under these conditions tends to be self-defeating.
3. Now suppose that the government, inadvisedly, decides to create a deficit, as under the first alternative, but to finance this deficit, not with money creation, but with public debt issue. Here the results are identical with those treated with respect to the fiscal policy operations of the local governmental unit in the wholly open economy. The only difference between these two cases is that the much larger national economy can expect a higher local income multiplier to be operative; potential leakages will be largely internalized. Through selling debt instruments in this model, the national government is effectively borrowing on the world capital market. It is adding directly to the national spending stream without creating new money directly. The operation becomes, in effect, equivalent to external borrowing.
If the first alternative is not possible, this third alternative may, of course, be recommended. However, when the first alternative is available, as it should be in all cases where the governmental unit does possess the power to create money, this third alternative is not efficient. It involves the creation of a future tax liability due to the necessity of servicing the debt that is created. This sort of liability simply does not exist under the first alternative since interest is not paid on money.
National Fiscal Policy Under Fluctuating Exchange Rates in an Open International Economic Order. Using the same basic assumptions as before, let us now examine the same three policy combinations under a regime where exchange rates are allowed to fluctuate freely.
1. The government creates a budget deficit (or allows one to emerge) during periods of threatened declines in total spending; it finances this deficit with money creation. Aggregate spending is maintained at the desired level. No pressure is put on interest rates, and the price level does not change. There is no change in the exchange rate.
2. The government may try to accomplish the same objective with orthodox monetary policy. It directs the monetary authority to enter the open market and purchase securities. This action puts downward pressure on interest rates. Capital tends to flow out of the country; the exchange rate falls. This, in turn, generates an expansion in exports. Income and employment are maintained. This policy combination seems to be successful here whereas it was unsuccessful under a regime of fixed exchange rates.
3. Suppose now that the government creates a budget deficit and finances this deficit with the issue of public debt. The sale of securities tends to raise interest rates domestically; but this will attract capital into the country and upward pressure will be put on the exchange rate. This will, in turn, discourage exports and encourage imports. In the net, there may be little or no effect on domestic income and employment because, in equilibrium, the interest rate may not have changed and the money supply may not have increased. The fiscal policy action in this instance will fail to accomplish its desired purpose of shoring up domestic spending on goods and services.7
Why does fiscal policy fail here? It does so because the exchange rate effectively isolates the domestic and the foreign capital markets, and prevents the flow of foreign capital to the country that takes place under the fixed-rate system, and which serves as a possible base for expansions in the domestic money supply. The increased spending flow generated here by the deficit-financed purchases of public goods and services is offset by the increased foreign drainage resulting from the shift in the exchange rate.
The most interesting, and seemingly most paradoxical, conclusion stemming from the analysis of the various models here is that the efficacy of debt-financed deficits in shoring up local income is greatly enhanced when the institutions are such as to make this debt external in its essential respects.
Under a regime of flexible, as well as fixed, exchange rates, the first alternative seems to be recommended. A positive fiscal policy that incorporates the possibility of generating budget deficits during periods when total spending threatens to fall below desired levels along with the provision that these deficits should be financed with money creation can emerge from the rational constitutional choice calculus of the individual. Similar adjustments may, of course, be included to allow for fiscal adjustments in the event of threatened or actual inflation. These have not been traced here.
It is important to note, to repeat, that the creation of public debt, as such, is never indicated for those governmental units that possess money-creating power as a part of the positive fiscal policy instruments under their control. It is clearly inefficient to create debt which requires a payment of future taxes when money can be issued without such service charges. Public debt should remain as a part of an over-all “fiscal constitution” of such governments only for issue during periods of high-level employment. For lower-level governments, as well as for private citizens, deficits must be financed by debt. In this case, a positive fiscal policy embodying debt issue may be efficient.
Fiscal Nihilism and Beyond
This book is an attempt to develop, in a preliminary fashion, parts of a theory of fiscal choice. The central presumption is that individuals do make fiscal choices through their participation in political process. If the potential taxpayer-beneficiary has no part in choosing either the private goods-public goods mix or the institutions through which he pays for and enjoys public goods, there is little purpose served in any analysis of the feedback effects of such institutions on his behavior. The traditionalist moves from analysis to prescription without necessary recourse to individual preferences. He sets up criteria for fiscal reform without asking how individuals themselves make fiscal choices. Since he must presume that individuals have little or no power of ultimate choice, resort to extra-individual, external norms becomes acceptable, indeed essential, if anything at all is to be said.
This is intended to be an indictment of orthodox scholarship in public finance, but not to be an undue criticism of practicing scholars. Within the tradition, effective research has been accomplished, and the frontiers of knowledge have been pushed into continuing retreat. But what is most urgently required is precisely a shift out of this tradition, out of the mainstream. Essentially the orthodox tradition is nondemocratic, with no emotive significance intended. Decisions for the polity must be made exogenously to the individual citizen and coercively imposed upon him.
If political order is presumed to be workably democratic, individuals must be presumed to participate variously in the making of fiscal choices. They may, of course, do so quite indirectly and at times almost unconsciously, but their behavior becomes a proper subject of scientific inquiry. The awesome gap in our knowledge is apparent here. We need to know much more about how individuals behave in collective decision processes, and we need to know more about the workings of those institutions that transmit and translate individual preferences into collective outcomes.
But what about norms? Where are “principles” to be found? What are the criteria for fiscal reform? Should A or B be chosen? Does the model of individualistic fiscal choice simply ignore such questions, or does it point to its own prescriptions? Is fiscal nihilism the ultimate outcome? Does the approach produce effective criticism of long-established norms while replacing these with none of its own making? The traditional objectives of equity and efficiency may be shown wanting, but they have provided a frame for discussion. What is proposed or implied in their stead?
The institutional-choice analysis has suggested a partial answer to such questions. Hopefully, such an analysis of fiscal choice processes can provide a basis for laying down criteria for reform. But what will these criteria be like? If individuals are presumed to choose for themselves, how can analysis do other than examine choice behavior and attempt to predict the outcome? To “improve” choices here must the specialist become a moralist who preaches a new choice ethic? Perhaps the answer is implied in the question. Improvements in individual choice behavior can result from positive analysis. Fiscal theorizing at this level has, as its ultimate purpose, objectives that are analogous to those that guide “consumers’; research,” “operations research,” or “systems analysis.” The ultimate choice-makers, whoever these may be, can make “better” decisions to the extent that they are made more fully informed as to the alternatives which they confront. Analysis has as its purpose the clarification of the various alternatives, the prediction of the consequences of the separate lines of action.
The Theory of Incidence
Properly interpreted, the whole of the theory of fiscal incidence can be incorporated in the fiscal choice approach. Surely it is equally appropriate for the theorist to assist, ultimately, in the choice-making of individual citizens and in the presumed choice-making of some ruling authority. For the bulk of the work on incidence theory, the underlying political framework remains essentially unimportant.
The student of fiscal incidence and effects does not inquire about and is not concerned about the origin of or the selection among the alternatives that he analyzes. His task is that of predicting the comparative effects of different fiscal devices, real or imagined. He examines individual market responses to imposed fiscal phenomena, and he traces the primary, secondary, and tertiary stages of such responses to a point where final patterns of effects can be isolated.
Even within incidence theory, there remain gaps in the traditional analysis that have gone largely unnoticed because of the underlying political framework. The specific objective of incidence analysis has been that of predicting the real effects of alternative fiscal devices, of locating the real pattern of final burden of taxes and benefits from public spending. Who does pay the taxes? Who does enjoy the benefits? These are important and relevant questions that should interest the fiscal decision-maker, whoever he may be. There are, however, less apparent but nonetheless significant questions that should also be asked, and, if possible, answered. Who thinks that he pays the taxes? Who thinks that he enjoys the benefits?
Incidence theory has largely ignored these latter questions. To an extent, this neglect is explained by the fact that scholars have been economists, not psychologists. And as economists they have properly concentrated on real, rather than apparent or illusory, values. This apart, however, they have been uninterested in individuals’; attitudes toward fiscal devices or instruments, as such. The emphasis has been, on the one hand, in predicting the allocational responses to fiscal changes, and, on the other, in determining the real pattern of final effects. The policy objectives that have been implicit in traditional scholarship, those of economic or allocational efficiency and distributional equity, have in this way exerted feedback effects on even the most positivistic elements in incidence analysis. The theorist who has operated within the orthodox allocational framework has been interested in predicting how an individual will respond in the marketplace when the retail price of a final product is increased due to the imposition of an excise tax. He has been unconcerned, or relatively so, about whether, in making this response, the individual attributes the price change to the tax or to any of the many other possible causal factors. The same theorist, who may have had implications for distributional equity in mind, has also been interested in imputing directly to the individual consumer a final share, in either relative or absolute terms, of the net burden that a tax embodies. How much does the individual really pay, absolutely or in proportion to some income-wealth base? Implicit here lies the presumption that the “social welfare function,” the preference function for the “chooser” for the group, incorporates somehow the real pattern of incidence rather than any apparent or consciously realized pattern.
It is evident that questions about the individual’;s attitude toward the fisc, toward taxes and benefits, become important either in an explicitly defined ruling-class, elitist model of politics or in an individual-choice, democratic model. How conscious are taxpayers of the burdens involved in the costs of public services? How conscious are beneficiaries of the values of public goods? Such questions as these become vital in any model that presumes that individuals make their own fiscal choices, directly or indirectly. The whole problem of fiscal consciousness is relevant for fiscal choice, and, in one sense, real burdens and real benefits become important only to the extent that they are effectively translated by individuals into “felt” or “consciously realized” burdens and benefits.
If viewed in this perspective, the discussion contained in Part I of this book can be treated as an extension of incidence theory. Analysis there was aimed at predicting the effects of various fiscal instruments on individual choice behavior in political processes.
The Theory of Public Goods
Traditional public finance theory has been concerned primarily with individual choices in response to imposed fiscal conditions. In this book, we have discussed two additional levels of individual choice behavior which, combined, provide the elements of specifically fiscal choice. There is what we have variously called day-to-day, in-period, ordinary, operational, or budgetary fiscal choices. By these descriptive terms we have meant simply that, under any institutional setting, individuals will exercise their powers of decision and select somehow among alternative possible outcomes. Given any conceivable tax structure, and given any conceivable rule for amalgamating separate individual choices into a group decision, a specific set of public goods and services will be financed, purchased, and supplied. Apart from this level of choice, and in one sense “superior” to it, there is the stage or level where the institutional structure itself is selected. This level of choice has been the subject of attention in Part II where it has been suggested that many fiscal instruments can best be analyzed institutionally.
The operational level or stage of fiscal choice has been examined only indirectly in this whole book. The analysis of Part I was aimed at developing certain predictions about the influence of various institutions on this choice behavior of individuals, but the discussion did not contain the process of choice itself. Quite apart from the universal problem of space and time limits, there are reasons for this relative neglect. In the first place, the formal theory is quite complex, and many elements remain to be perfected. Secondly, and more importantly, the modern theory of public expenditure, which is surely the most exciting recent work in public finance literature, can be brought within the over-all framework of this study without difficulty. Shorn of its occasional “social welfare function” overtones, which become both unnecessary and impossible in an individualistic model of political order, this modern theoretical construction may be interpreted in such a way as to allow predictions to be made about the outcomes that will tend to emerge from the complex interplay of individual preferences as these are expressed through collective decision-making processes.
In its standard formulation,1 this theory of public-goods supply is explicitly normative. It purports to lay down the necessary marginal conditions that should be met if economic resources are to be allocated optimally in the public sector. Optimality or efficiency in resource use is defined in the Paretian sense, and a single optimum point or position (any one from among an infinite number of such points or positions) is defined as one from which no change can be made without harming at least one person in the relevant group. The necessary marginal conditions that must characterize such a position are defined without reference to nonindividual norms and also without reference to the political or institutional processes that might produce such an outcome. The standard discussion stresses that such optimal outcomes cannot, in fact, be predicted to emerge from the private or independent behavior of individuals, analogous to that pressure toward optimality which does characterize behavior in market interactions. Individuals will rationally behave as “free riders” in trying to enjoy public goods and services; as a result they will tend to find themselves caught in a “many-person prisoners’; dilemma.”
Given this widely accepted and explicitly normative version of the theory of public goods, how may it be transformed so as to enable us to predict the characteristics of the outcomes that will emerge from actual political processes? To construct this bridge between the formally correct and abstract normative theory of public-goods supply (which is derived from the theoretical welfare economics that owes its origins to Vilfredo Pareto), it is necessary to go back to one of Pareto’;s own contemporaries, Knut Wicksell. In any over-all evaluation of the history of fiscal thought, Wicksell alone commands the heights of genius. He worked independently from Pareto, of course, and his own discussion of the “principles” for fiscal organization seem, at first glance, quite different from the formal statements of necessary marginal conditions that we associate with Paretian welfare theory. Wicksell was equally the armchair theorist, but he framed his whole discussion of fiscal choice in terms of political institutions, in terms of the processes through which individual preferences are translated into collective or group decisions.2
Wicksell suggested that the unanimous consent of all parties should be the criterion for decisions on fiscal matters. Although it was developed independently, it is evident that this criterion is the political counterpart of the Pareto criterion for optimality. If, from a given position, no change can be made through general agreement among all parties, the initial position may be classified as one belonging to the optimal or efficient set. On the other hand, if a change is proposed and all members of the group agree to this change, the initial position is nonoptimal. Wicksell’;s discussion contains specific institutional suggestions for implementing the rule of unanimity in the reaching of fiscal decisions.
In this Wicksell variant, the theory does become a theory of fiscal choice in a positive sense. If an institutional rule is imposed to the effect that all fiscal decisions, all taxing-spending decisions, must be made only after the unanimous agreement among all parties, the necessary conditions for optimality, defined in the Paretian sense, will characterize the outcomes that tend to emerge from the collective choice process. The only qualification that need be placed on this general proposition is that choices must be made marginally or in small steps. The theory of fiscal choice, so interpreted, does not, of course, allow us to predict what outcomes will tend to emerge. The Pareto surface contains an infinite number of optimal positions or points, and, at each stage of the journey toward this surface, the division of the “gains from trade” among persons will tend to restrict the size of the finally attainable set. The theory enables us only to define the characteristics of the solution, not to specify the elements contained within it. In this sense, the theory of fiscal choice is wholly analogous to the “theory of consumer’;s choice” which is a standard part of the economist’;s equipment.
While Wicksell does provide us with a bridge between the normative theory of “optimal resource allocation” and the positive predictions that may be desired in an individualistic model, the severe restrictions that his institutional constraints impose on individual behavior in collective choice must be acknowledged. Under a genuine rule of unanimity, individuals will be led to invest resources in strategic bargaining, investment which will, in the net, prove wasteful to the group as a whole. This type of individual behavior is not the same as the “free rider” sort which would characterize individual attitudes toward voluntary contributions for public goods. Under unanimity, some agreement might ultimately be reached at each stage on the way to a final outcome, but serious resource wastage might occur, the most important element of which would be measured in the costs of delaying agreement. Decision-making in groups, bargaining, is a costly process at best, and costs may become prohibitively high under a rule of unanimity, despite the acknowledged relevance of this rule, and this rule alone, for guaranteeing that action taken is, indeed, of net value for the group.
Wicksell sensed the problem here in his expressed willingness to allow for some relaxation of the institutional rule of unanimity, and in his specific proposal for a qualified legislative majority—although he left the precise size of his majority ambiguous. If the rule of unanimity is relaxed, the single participant in group choice cannot proceed on the assumption that his own agreement is required for collective decision. He will be much less inclined to invest resources in bargaining tactics. Decision-making costs are reduced dramatically. At the same time, however, any departure from the strict unanimity requirement means that inefficient or nonoptimal outcomes may emerge. The final result of the collective decision process need not be Pareto optimal; the necessary marginal conditions need not be satisfied.
What is suggested is some balancing off of the two sides of the account, some comparison of the costs of inefficient or nonoptimal outcomes with the reductions in costs (benefits) that are expected to arise from the facilitation of decision-making. This is essentially the comparison that Gordon Tullock and I discussed at some length in The Calculus of Consent, although the analysis there was not confined to fiscal choice.
Once this step is taken, the theory moves beyond the operational choice level into considerations of institutional-constitutional choice, the level or stage discussed in Part II of this book. Through some calculus of comparing costs, it becomes possible to discuss optimal rules and institutions within which choices are to be made, choices which are, themselves, predicted to produce outcomes or solutions that are not always located on the standard Pareto surface. What becomes conceptually predictable under this theory is not the characteristics of particular outcomes, but, instead, the general features of a whole probability distribution of outcomes. We shall return to a further discussion of this theory of institutional choice in a later section. Before this, however, it will be useful to return to the level of in-period budgetary choices. The discussion of the possibilities of developing positive theories of fiscal outcomes has not yet been exhausted.
Fiscal Choice Under Fixed Institutions
At any moment in time, some political “constitution” exists that specifies the manner in which collective decisions, including fiscal decisions, shall be reached. This structure may be described in detail only by the complex rules and procedures governing the whole set of political institutions. This very complexity makes it incumbent on the theorist to abstract the essential elements of the structure, to simplify, and to construct models of political choice-making. With these models, he may then try to predict the characteristics of the outcomes that will emerge. Any realistic model will, of course, incorporate a political decision rule that requires the assent of less than all members of the group. One such model is simple majority voting, a model that was introduced and discussed in Chapter 11. Under such an operative rule for reaching group decisions, what characteristics of final outcomes can be specified? Some analytically meaningful results can result from attempts to answer this question; the literature on the solutions to majority-rule games and on majority-coalition formation is relevant and important. Somewhat more restriction may be placed on the analysis of fiscal outcomes if additional constitutional constraints are imposed on the models. In addition to the majority-voting rule for making political choices, it is possible to fix the institution under which taxes are to be paid, through which public goods and services must be purchased. Through this dual set of institutional-constitutional restrictions, the outcomes of the fiscal choice process may be somewhat more narrowly circumscribed and the analysis made somewhat less general than in unconstrained majority-rule models. Only in Chapter 11 has this sort of theorizing been attempted in this book. The exploratory efforts there are presented more or less as lead-ins for further possible research. Both the rules for making political decisions and the institutions through which fiscal outcomes are produced are subject to wide variations, even within the framework of any existing political-fiscal order.
What results are to be expected from such theorizing? No model that allows for genuine individual choice can predict the precise outcomes that will emerge from a decision process, whether this be the private choice of a single person or the collective choice of a group of persons. The economist, the theorist of consumer’;s choice, cannot predict the mix of goods that a particular housewife will purchase in the market. Similarly, the fiscal theorist cannot predict the particular mix of public goods that will be chosen by a community of persons. But it may be useful to extend this comparison with the theory of consumer’;s choice somewhat further here. As suggested above, only under the somewhat rarified institutional assumptions imposed in the Wicksellian model can the outcome of the fiscal choice process be described by the familiar equalities among marginal rates of substitution. Under almost any remotely relevant institutional restrictions, the outcomes will tend to be nonoptimal in the Pareto sense. If the limits of theory are exhausted with the classification of particular outcomes into nonoptimal and optimal sets, there would be little purpose in the analysis of differing institutional structures. Something more than mere classification of outcomes within the nonoptimal set can be made. The various institutional combinations can be arrayed in terms of the predicted degree of “nonoptimality” of the outcomes that they are expected to produce over a whole sequence of separate decisions.
Our attention in this book is concentrated primarily on fiscal institutions, not on the institutions of political decision-making. The procedure suggested, therefore, is that of attempting to array alternative fiscal arrangements under each possible political decision structure. As an illustration, refer to the models introduced in Chapter 11. Assume the presence of simple majority voting for reaching all political decisions. The next step is that of comparing predicted outcomes under separate and alternative fiscal institutions. Compare, for example, the outcomes to be predicted under a head tax with those under a proportional income tax. Which of these series of outcomes seems to be “preferred” on efficiency criteria? The Pareto criteria can serve as the benchmarks from which possible departures are measured.
It is useful to recall that the choice of a tax institution can serve as a substitute for a decision-making institution and vice versa. Conceptually, in decisions on the appropriate quantity of a single public good, there will always exist some tax institution which will produce “optimal” outcomes, under any and all rules for reaching a collective decision. The more “efficient” the tax institution is in this sense, the less “inefficient” will be any given departure from unanimity in the political decision structure. This point was illustrated in some of the models developed and discussed in Chapter 11. If the tax institution should be such that each person is obligated to pay for public goods so that tax-prices equal the schedule of marginal benefits, any conceivable decision rule will yield the Pareto-optimal quantity of public goods. The fact that such a tax institution always exists conceptually does not, of course, imply that it can be determined independently of the revealed choices of individuals themselves. If an omniscient observer should be present, and if he were asked to “read” all individual preference maps, he could then describe the “optimal” structure of tax-prices. Failing this, there is no means of ascertaining with any degree of accuracy the “efficient” tax structure or institution.
If the tax institution is not the “efficient” one, either because its selection cannot be made independently, or because nonefficiency criteria are also relevant, then the political decision rule can be important in determining the degree of efficiency in the outcomes that emerge. For example, if the tax rule states that all persons must pay equal taxes, then the delegation of political decision-making power to a single person produces less inefficiency than such a delegation would produce under no such tax restriction. The dictator’;s possible exploitation of his fellows is reduced by the requirement that he, like his fellows, must pay a share of the total tax load. Since, in the normal order of events, the tax institutions in existence will not approximate those that are “efficient,” analysis must consider carefully the effects upon outcomes produced by various political decision rules. In this analysis no simple conclusions can be reached by trying to array alternative political institutions under separate fiscal arrangements. For example, suppose that the constitution dictates that all public goods shall be financed by equal taxes on all persons. It does not follow at all that the “efficient” decision rule, that of unanimity, will produce “optimal” results for any and all tax allocations. It seems obvious that unanimity in this case of equal taxes might be one of the worst of rules for reaching group decisions. There may exist some “efficient” decision rule in a regime of poll taxes, which an omniscient observer could specify, but it becomes extremely difficult to think of meaningful procedures through which such a rule could be independently discovered. For this reason, it seems preferable to consider the political decision rules as being, somehow, less subject to deliberate variation than the fiscal institutions.
The suggestion was made above that various fiscal institutions could be arrayed or ranked in terms of their predicted ability to produce “efficient” outcomes, these being defined in the standard Pareto fashion. This raises the whole question of norms once more. Is the suggested procedure not equivalent to reintroducing the economist’;s normative standard? If so, what has become of the model in which individuals are simply observed to choose what they will?
There is no paradox here when the proper relationship between the criteria of efficiency and individual choices is recognized. What does the economist mean by an “optimum allocation of resources”? He really means that allocation which is produced by the uninhibited interplay of private individual choices and nothing more. The extension to the supply of public goods is straightforward. An “efficient” public-goods provision is that which would tend to emerge from the “ideal” institutions of individual-collective choice. It becomes appropriate, therefore, to discuss various institutions in terms of their predicted tendencies to promote or to prevent the attainment of such outcomes. No external ethical norms concerning the actual shapes of these outcomes need be introduced at all in order that some institutions may be called “better” than others, by efficiency criteria. An analogy may be helpful. We may say that a clear windshield is “better” for driving an automobile than a dirty windshield, without any reference to where the driver wants to go. Given any route, he will drive “more efficiently” if he is able to see where he is going. Similarly, we may say that certain institutions are “better” than others, quite independently of the outcomes that will be produced. Whatever these may be, they are reached more efficiently under some institutions than under others.
The incorporation of the traditional equity norms into the individualistic model cannot be accomplished so readily. Some of these issues will be discussed in a later section. First, however, there is more to be said concerning efficiency.
The Choice Among Fiscal Institutions
For what purpose does the analyst array the various fiscal institutions in the procedure suggested above? Ultimately at some higher-stage or higher-level “constitutional” choice, individuals themselves must select the set of fiscal institutions, rules, and regulations under which in-period budgetary choices shall be made. The vital distinction between fiscal choice under specified and preselected institutions and the choice among such institutions themselves cannot be overstressed, and a simple example may prove helpful even at the expense of repetition with earlier discussion. Consider a group of persons organized as a political community, and for simplicity think of the political constitution as having been fixed. But no fiscal constitution exists. The opportunity, or the necessity as the case may be, arises for some group outlay on a public good or service, say, defense against external enemies. The community, acting as a unit, must decide on how much of this public good to supply, and it must decide how the costs shall be distributed among the citizens. These two separate decisions are interdependent under any political choice rule. An individual’;s behavior in voting for public goods will be influenced by his predictions as to the tax allocation. As we have previously noted, it is in this setting that the “free rider” problem emerges to complicate and to confound fiscal decision-making.
One means of sharply reducing the investment in strategy and of generating directness in individual response is for the group to reach some agreement on how the tax-costs shall be distributed among persons in advance of and independently of the decision on public-goods quantity. In our example, the community may approve a “fiscal constitution” even before any need or opportunity for spending on external defense is anticipated. This institutional or constitutional choice implies, of course, that some inefficiency in any final outcome as measured in public-goods supply must be predicted as highly probable. In the example here, if the fiscal constitution agreed upon dictates that all public goods, including defense, must be financed from head taxes imposed equally on all citizens, the specific supply of defense in any particular period may diverge considerably from that which would be “optimal.” Given sufficient investment in bargaining and discussion, some rearrangements of tax shares might be worked out that would enable the community to shift somewhat closer to the Paretian welfare surface in almost every particular case. When, however, it is recognized in advance that such rearrangements would have to be worked out for each separate public good or service supplied and in each separate time period, the costs of securing reasonably efficient outcomes may become prohibitive. Some structural adjustment in the direction of selecting tax allocations that determine individual cost shares (individual tax-prices) over a large basket of public goods and services and over a whole series of time periods may be individually and collectively rational.
Once this is recognized, the whole notion of “efficiency” is necessarily modified. An institution may well be “efficient,” even though it is recognized that “inefficient” outcomes will be produced through its operation. The central question in institutional choice is that of selecting the most “efficient” institution. What scheme or rule for collecting taxes is relatively most efficient when the public goods to be supplied from the tax revenues remain wholly unspecified? As noted in Chapter 14, this shift to institutional choice seems partially to rehabilitate traditional fiscal theory and to justify a consideration of “tax principles” independently from the expenditure side of the fiscal account. Efficiency here must be discussed in terms of the probability distribution of outcomes that a tax institution is predicted to produce over a series of separate time periods and over a series of different benefit imputations.
A New Approach to Fiscal Justice
The methodology for the analysis of institutional efficiency is drawn from several sources: the modern theory of statistical inference, the theory of games, the theory of political constitutions, and, also, recent philosophical discussions of “justice.”3 This latter discussion is especially relevant since it allows us to relate the institutional-choice approach to the traditional discussion of justice or equity that has occupied so much of the fiscal literature. The methodology that embodies as its characteristic feature a sharp differentiation between the outcomes of a choice process and the rules or institutions that generate such outcomes is, of course, wholly different from the traditional approach in fiscal theory.
How will an individual choose among the alternative institutions of taxation? In an idealized position of choice here, the individual is uncertain both as to his own share of the benefits that might accrue from the spending programs that may be adopted and as to his own economic position (upon which taxes would presumably be based). In such a situation, he must try, as best he can, to choose an institution that will work tolerably well under almost any set of circumstances. The analogy with the choosing of rules for an ordinary game of poker is a close one. The individual will try to select rules that seem to be “fair.” At this level of consideration, “fairness” and “efficiency” merge and come to mean the same thing. It seems also appropriate to use the word “justice” here, as Rawls has done in his discussion of ethical norms. In terms of some normative personal ethic, the individual “should” choose as if he is in such an idealized position, even if he is not, and the criteria for his decision can be summarized as those of “justice.”
Our central concern is not, however, with the ethics of individual behavior, but rather with the prediction of behavior in institutional-choice situations. Normally individuals will not find themselves in the idealized conditions. A person will probably have some idea as to the pattern of benefit imputations over time, and, even more probably, he will have some idea as to his own economic position in future periods. Nevertheless, it is not unreasonable to suggest that uncertainty elements in both respects loom relatively important in his decision calculus, and to the extent that they do so, it is appropriate to examine the notions of both “efficiency” and “justice” in the framework discussed here.
Theoretical welfare economics enables us to define the necessary marginal conditions that must be satisfied for an allocation of economic resources to be efficient. Straightforward extension of this analysis to “theoretical institutional economics” should enable us to define a similar set of conditions that would have to be met if an institutional arrangement or rule is to be classified as “efficient.” It now seems quite possible that future developments will in fact allow for general statements of such conditions. At this time, however, we must be content with more ambiguous and less rigorous definitions. Analysis remains at the stage of examining various institutions under varying sets of assumptions, with criteria for efficiency being largely derived from introspection.
It was noted above that the criteria for “efficiency” and “justice” merge and become identical under the institutional-choice approach, at least in its idealized form. This is, of course, sharply at variance with public finance orthodoxy, where these two objectives are distinct. “Equity” or “justice” has been traditionally held to require the introduction of external ethical norms. A long-standing principle of normative public finance theory has been that “equals should be treated equally,” the principle that has been called one of “horizontal equity” by R. A. Musgrave.4 Corollary to this, there has been the principle of vertical equity: “Unequals should be treated unequally.” But to what degree? This has remained the central issue in normative tax theory, and it has been resolved only upon the introduction of some external value scale, some “social welfare function” that is defined by the observer. Since individuals have no part in the formation of this scale, except as the observer chooses to take their preferences into account, the conceptual task of the analyst is simply that of “reading off” the solution that best achieves the indicated equity objective.
In its most modern formulation, represented in Musgrave’;s treatise, fiscal theory contains a paradox. The allocative function of the fiscal mechanism is sharply differentiated from the distributive function. In the former, individual choices are allowed to serve as the basic determinants of outcomes, at least in some normatively idealized sense. In the latter, however, resort to an external value scale is necessary. “Efficiency” criteria are derived from individual preferences; “equity” criteria are derived from external sources. Hence, efficiency and equity not only represent different and often conflicting objectives; they are also different philosophically, being derived ultimately from two quite distinct sets of values.
In the modified approach proposed here, these two sets of criteria become one, and both are derived from individual preferences. A fiscal institution that is efficient is also just, and vice versa, since these terms cannot be distinguished in the individual institutional-choice context. The individual who is presumed to be making a choice among alternative fiscal institutions does so on the grounds of his own utility-maximization. This insures that he will tend to select that institution or rule that he considers most efficient privately considered. But this institution will also tend to be that which is considered just for the simple reason that the individual cannot predict with accuracy his own position under the subsequent operation of the institution. He will be led to choose an institution that will treat him “fairly” or “justly” wherever he might find himself located.
To the extent that the individual’;s actual choice position is not that defined in the idealized model, the efficient fiscal instrument for him will not be that which would be observed to fulfill criteria for “justice.” To the extent that the individual can predict with accuracy the future imputation of public benefits and/or his own income-wealth status, his utility-maximization will lead him to select institutions that will provide differential advantages. As previously noted, and as will be discussed again below, it is the recognition that this conflict will arise which makes the importance of the conditions for institutional choice so important and points the way toward proposals for reform aimed at shifting these conditions.
The Redistributive Function
The two approaches, the orthodox or traditional one and that which has been partially developed in this book, may be compared in their treatment of the income-wealth distribution problem and its relationship to the fiscal mechanism. As suggested, the standard treatment here explicitly invokes external norms. For example, Henry Simons accepted “greater income equality” among individuals as a social objective that the fiscal system “should” be organized to promote. Modern works call on some “social welfare function” to determine the single most-desired point from among the infinite set of the Pareto welfare surface.
This resort to external norms is eschewed in the individualistic model. Is it then possible to say anything at all about the redistributive function of the fiscal mechanism? There are two separate levels of response to this question which must be kept distinct, again illustrating the relevance and importance of the two stages of fiscal choice that have been emphasized. If an individual’;s economic position is clearly identifiable, along with those of his fellows, and if a single one-period choice is confronted, he may, of course, choose to tax himself for the purpose of transferring income to those less fortunate than himself. In this sense, redistribution is a public good in the classical form, and there are evident externalities to be internalized by collectivizing the “consumption” of this good. Therefore, even in the purely individualistic model that is confined to single-period choice, some net redistribution would tend to be carried out by the fiscal system. The limits of this income transfer would be quite confined under normally expected circumstances, however, and this transfer would depend on the fact that individuals include the utility of others than themselves as arguments in their own utility functions.
Redistributional elements become much more important at the second or institutional level of fiscal choice. Under the idealized conditions, the individual cannot identify his own income-wealth prospects over time with accuracy. Hence the choice-maker should, rationally, act as if he confronts a probability distribution of possible income-wealth positions, and he should select that fiscal structure that maximizes expected utility. It is easy to see that the individual might under these conditions build in important elements of net income-wealth transfer, not because he pays any attention at all to the utility of his fellows, but simply because he wants to insure for himself a satisfactory post-fisc income level. There will surely exist some “optimal” degree of net redistribution, and this will tend to be considered in the individual’;s choice of a fiscal constitution under almost any political decision rule. It is to be expected, therefore, that net redistribution will characterize the operations of the fiscal constitution over time.5 It is reasonable to suggest that this sort of calculus is helpful in “explaining” redistributional elements that are found in modern fiscal structures, perhaps even more helpful than the vaguely asserted notions of equalization presumed in the standard treatments.
Directions for Reform in Fiscal Structure
The analysis of this book has been basically positive. The purpose has been that of predicting the effects of specific institutions upon fiscal choice and of predicting the types of institutions that might be selected. The discussion of the underlying efficiency norm was presented through its derivation from individual preferences rather than in the more usual shorthand conception which seems to imply that the criterion is independently discovered. The analysis does point toward general normative conclusions, however, and it is appropriate that some of these be outlined briefly in this section.
Given the complexities of modern budgets and the large numbers of individuals who hold membership in most governmental jurisdictions, it takes little or no theorizing to suggest that any attempt to attain efficiency in the supplying of each and every public good and service in each and every fiscal period would be economic as well as political folly. Public goods must be supplied within the context of a fiscal constitution, which is described as a quasi-permanent and quite complex set of institutions and rules that specify what tax instruments are to be employed and when and how, when public debt is to be issued, how budgets are to be made, etc. What must be sought for, realistically, in any reform, are “improvements” in this fiscal constitution. How can those elements that seem to produce inefficient results be eliminated and more efficient elements substituted?
The standard procedure is for the expert to place himself in the role of constitution-maker and to discuss the drawing up of the “ideal fiscal structure.” This procedure remains possible, and the interpretation of justice-as-efficiency sketched above suggests that considerable material of interest might be developed in this fashion. Such an attempt would, however, probably be foredoomed to failure. No effectively democratic society would be disposed, nor should it be disposed, to turn over the remaking of its fiscal or political constitution to a single expert or to a body of experts.
Recognizing this, the student of the fiscal process can begin a less exciting but more productive task. He can try to suggest specific changes in the ways in which individuals make constitutional choices rather than changes in the choices that “should” be made. He can suggest modifications in the structure of choice itself that may lead individuals, through the political decision procedures, to choose more efficiently among alternative fiscal instruments. As noted, individuals will tend to equate efficiency with justice, properly interpreted, if they are confronted with institutional-constitutional choice in its idealized setting. It is possible in many circumstances to suggest changes which have the effects of placing individuals closer to such situations. The first requirement is that all genuinely constitutional changes (whether they be called this explicitly is largely irrelevant) should be treated by individuals as quasi-permanent or long-run changes. The most important single improvement in the fiscal system might well be the introduction of specific lags between decision and implementation along with the requirement that decisions, once made, must remain in force over some minimal period of time.
An illustrative example is provided in inheritance and estate taxation. In the standard discussion of fiscal reforms, merely to raise issues concerning this tax is to choose sides. And the choosing is not difficult. Those persons who identify themselves with favorable asset positions tend to argue persuasively against increases in and for reductions in such taxes. Those other persons who cannot or do not make this identification argue, with equal persuasiveness, that these taxes should be made confiscatory. The collective decision process becomes strictly analogous to a zero-sum game, and no reasoned discussion of an efficient or optimal scheme or asset-transfer taxation can possibly take place.
How may this state of affairs be improved? Surely not by the various experts posing as authorities and invoking time-honored principles to support their own personal preferences. The inference to be drawn is that changes in asset-transfer taxation cannot be discussed dispassionately so long as these are discussed as current changes. Therefore, the implication is that modifications in the structure of such taxes should, ideally, be discussed only with significant time lags between decision and action. Reasoned, and reasonable, discussion should be possible on the most efficient structure of asset-transfer taxation that would come into effect in, say, a quarter or a half-century after decision. Individuals who participate in the discussion on this basis will be unable to identify their own positions so clearly; their self-interest will be long-term. This proposal seems farfetched only because it has not been explicitly examined, although the familiar Rignano plan can be interpreted as a vague normative statement of the same idea.6 This is presented here only as a simple and single example of the sort of reforms that might be expected to improve the choice among fiscal institutions. No exhaustive discussion of such reforms will be made here, and none is found in this book.
Time is, of course, the element that converts an interclass, intergroup decision into a reasoned one on which general agreement becomes possible. Different time lags may be appropriate for different institutions. Time has rarely been treated as a variable by economists, yet it seems evident that the temporal characteristics of a decision can have a major impact on the manner in which individual decision-makers evaluate and choose among alternatives. Everything is variable in the long run, including the individual’;s own economic position and the pattern of benefit imputation from public spending programs. The individual who may be quite eager to support a temporary one-year tax on new automobile purchases to finance a one-year subsidy to a world’;s fair in his home city, may be quite reluctant to support a permanent tax on new car purchases to finance annual world’;s fairs in a series of cities.
The Constitutional Attitude
The effective operation of democratic government, in its fiscal as well as its nonfiscal aspects, requires the adherence of its citizens to what may be called the “constitutional attitude.” Given the high cost of making collective decisions, government can function properly only if a large proportion of its day-to-day operations take place within a quasi-permanent constitutional structure. Individuals, and groups, must recognize the importance of constitutional-institutional continuity, and the dependence of democratic process on firm adherence to such continuity. If this is not recognized, and if individuals come to consider governmental processes as nothing more than available means through which separate coalitions can exploit each other, democracy cannot, and should not, survive. Fiscal institutions are a part of the political constitution, broadly considered, and especially in the sense noted here. Changes in the fiscal constitution must be treated as quasi-permanent and long-lasting features of the social structure. If individuals, and groups, including politicians, come to consider seriously the possibility of manipulating basic fiscal institutions for the accomplishment of short-run-purposes, bargaining elements will quickly swamp all efficiency considerations.
In the final analysis, “justice,” “efficiency,” “fairness,” whichever term is employed, can be expected with a reasonable degree of certainty only when individuals (or their representatives) are placed in the position of choosing for themselves, not as instant, momentary beings, but as a whole complex probability distribution of potentialities. To expect the poker player with a pat hand to agree to a new deal is to place entirely too much dependence on human ethics. The rules of the game, political or otherwise, may properly be drawn up only in advance of play, and by the players themselves. And, as play proceeds, rules should be changed to apply only to later rounds of play.
In fiscal theory, as in politics generally, scholars need to pay more attention to the working out of rules or institutions through which final outcomes emerge and less attention to the shape of these outcomes themselves although these must, of course, be relevant to an evaluation of the institutions. Improved allocations, or outcomes, can be achieved only through improvements in the institutions that generate them, and improvements in such institutions, in turn, can be achieved only if their proper role in the whole structure of democratic process is appreciated and understood. Perhaps more than their fellows, scholars themselves need to acquire a “constitutional attitude.”
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[1. ]The most complete attempt to work out such a model is contained in Charles J. Goetz, “Tax Preferences in a Collective Decision-Making Context” (Unpublished Ph.D. dissertation, Alderman Library, University of Virginia, 1964). Portions of this work are contained in Charles J. Goetz, “A Variable-Tax Model of Intersectoral Allocation,” Public Finance, XIX (February, 1964), 29-43.
[2. ]The problem as posed here with reference to the choice among fiscal institutions is methodologically equivalent to the problem of choosing constitutionally among alternative rules or institutions for reaching collective decisions. Cf. James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962).
[3. ]See my Fiscal Theory and Political Economy (Chapel Hill: The University of North Carolina Press, 1960), pp. 15-17.
[* ]Although it is developed somewhat differently, the basic theoretical model presented in this chapter is contained in my paper, “The Economics of Earmarked Taxes,” Journal of Political Economy, LXXI (October, 1963), 457-69, circulated also as No. 73, Studies of Government Finance Reprints, Brookings Institution, 1963.
[1. ]Henry Simons, Personal Income Taxation (Chicago: University of Chicago Press, 1938).
[2. ]Paul A. Samuelson, “The Pure Theory of Public Expenditure,” Review of Economics and Statistics, XXXVI (November, 1954), 387-89.
[3. ]Richard A. Musgrave, The Theory of Public Finance (New York: McGraw-Hill, 1959).
[† ]The analysis contained in this chapter was developed jointly with Professor Francesco Forte of Turin, Italy, in the spring of 1962, and the argument was first presented that year in a seminar at the University of Exeter, England. The analysis, in a somewhat different form, provides the basis for the paper, written jointly with Forte, “Fiscal Choice Through Time: A Case for Indirect Taxation?” National Tax Journal. XVII (September, 1964), 144-57, and circulated as No. 81, Studies of Government Finance Reprints, Brookings Institution, 1964. I am, of course, indebted to Professor Forte for his assistance in developing the argument, along with my other spillover effects this assistance might have had on other parts of this study.
[1. ]E. Barone, “Studi di economia finanziaria,” Giornale degli economisti (1912), II, 329-30, in notes.
[2. ]I. M. D. Little, “Direct Versus Indirect Taxes,” Economic Journal, LXI (1951), 577-84.
[3. ]Milton Friedman, “The ’;Welfare’; Aspects of an Income Tax and an Excise Tax,” Journal of Political Economy, LX (1952), 25-33, reprinted in Essays in Positive Economics (Chicago: University of Chicago Press, 1953), pp. 100-16.
[4. ]Earl R. Rolph and George Break, “The Welfare Aspects of Excise Taxes,” Journal of Political Economy, LVII (1949), 46-54.
[5. ]For a summary discussion that contains references to the other works, see M. J. Farrell, “New Theories of the Consumption Function,” Economic Journal, LXIX (1959), 678-96.
[6. ]For each time period, the standard necessary conditions hold. One of these is,
[7. ]We are concerned here only with the individual’;s calculus at t0. The fact that, when t1 arrives, he may have a different set of “optimal” plans need not concern us. On this latter point, see Robert H. Strotz, “Myopia and Inconsistency in Dynamic Utility Maximization,” Review of Economic Studies, XXIII (1956), 165-80.
[8. ]Care should be taken to distinguish postponable items of residual consumption from durable consumer goods. The durable goods-nondurable goods distinction need not concern us here, and we have assumed that all services are purchased as they are actually used. A postponable service is characterized by some nonrecurrence of “need” over time.
[9. ]The relationship between the analysis here and the traditional “double taxation of saving” argument should be explained. This latter argument, as developed by J. S. Mill, Irving Fisher, Luigi Einaudi, and others, supports the imposition of a general expenditure tax in lieu of a general income tax on efficiency criteria, holding that any income tax tends to discriminate against income that is saved. This argument assumes meaning, however, only when the distribution of the tax load among separate persons is introduced. It is not relevant here since the analysis is limited, specifically, to the calculus of a single potential taxpayer who is placed in the position of choosing among several instruments of payment. In the life-cycle pattern of saving behavior postulated, the present value of future spending must equal the present value of income receipts. If the individual is taxed on income received in each period, including income earned as a return on saving from previous periods, the rate of tax would tend to be somewhat lower than that rate which would be required to produce an equivalent present-value tax liability under some general expenditure tax.
[10. ]The general expenditure tax is assumed here to impose a pattern of final incidence among individuals in relation to spending. This is not the place to introduce complex issues of incidence theory. However, it may be noted that, even should the final incidence of the tax not be in this pattern, the analysis traced above will hold so long as, when he considers the alternatives, the individual thinks that the incidence will be proportionate to spending.
[1. ]For several years this result has been discussed among economists at the University of Virginia as “Tullock’;s fallacy,” since it owes its local origin to my colleague, Gordon Tullock. In a recently published paper, E. J. Mishan has indirectly noted the same point. See his “How to Make a Burden of the Public Debt,” Journal of Political Economy, LXXI (1963), 529-42, especially note 5. The point is, of course, implicit in the traditional Ricardian notion that the public loan and the extraordinary tax are fundamentally equivalent for the individual, since this argument assumes that the individual is able both to borrow and to lend at the government borrowing rate.
[2. ]The analysis of de Viti de Marco, although itself incomplete, is suggestive of the approach to debt theory developed in this section. See Antonio de Viti de Marco, First Principles of Public Finance, trans. E. P. Marget (New York: Harcourt-Brace, 1935), pp. 377-98.
[3. ]This is not the place to repeat the analysis that demonstrates that public debt does, in fact, involve a postponing or shifting forward in time of fiscal liability. On this, see my Public Principles of Public Debt (Homewood: Richard D. Irwin, 1958). The discussion among scholars on this subject since 1958 is collected in James M. Ferguson (ed.), Public Debt and Future Generations (Chapel Hill: The University of North Carolina Press, 1964).
[1. ]Institutional rigidities in the economy may, of course, prevent the maintenance of both full employment and price-level stability along this growth path. Resolution of this conflict need not be discussed here. If inflation threatens, the policy institutions suggested are, of course, the reverse of those discussed.
[2. ]The alternative institutional structure that might be designed to accomplish equivalent objectives is that one which allows strict adherence to in-period budget-balance, in the sense traditionally defined, and which then allows some governmentally created “monetary authority” to engage in “monetary policy.” During periods of depressed community income, this authority would purchase, with new money, securities held by the public.
[3. ]Although the list is by no means exhaustive, the following items may be noted: A. H. Hansen and H. Perloff, State and Local Finance in the National Economy (New York: Norton, 1944), especially Chapter 4; Mabel Newcomer, “State and Local Financing in Relation to Economic Fluctuations,” National Tax Journal, VII (June, 1954), 97-109; Ansel M. Sharp, “The Counter-Cyclical Fiscal Role of State Governments During the Thirties,” National Tax Journal, XI (June, 1958), 138-45; James A. Maxwell, “Counter-Cyclical Role of State and Local Governments,” National Tax Journal, XI (November, 1958), 371-76; Morton A. Baratz and Helen T. Farr, “Is Municipal Finance Fiscally Perverse?” National Tax Journal, XII (September, 1959), 276-84.
[4. ]This question is raised and discussed by Clarence Barber in his monograph “The Theory of Fiscal Policy as Applied to a Province,” A Study Prepared for the Ontario Committee on Taxation (June, 1964), especially in Chapter 2. I am grateful to the Committee for allowing me to have access to this study. Barber’;s work stimulated my own interest in elaborating some of the models of this chapter, and appropriate acknowledgment should be made of this fact.
[5. ]This has been recognized in a slightly different connection by Ronald I. McKinnon and Wallace E. Oates, “The Implications of International Economic Integration for Domestic Monetary, Fiscal, and Exchange Rate Policies,” Memorandum No. 37, Research Center in Economic Growth, Stanford University (May, 1965).
[6. ]The models discussed are essentially the same as those examined by R. A. Mundell in his provocative paper, “Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics and Political Science, XXIX (November, 1963), 475-95. See also the paper by McKinnon and Oates previously cited.
[7. ]As noted, this analysis follows closely that presented by Mundell, “Capital Mobility,” Canadian Journal of Economics and Political Science. He concludes that fiscal policy tends to be self-defeating in conditions of flexible exchange rates, and that monetary policy tends to be self-defeating under conditions of fixed rates. In effect, Mundell examines only alternatives II and III under each model, and he considers that fiscal policy must embody debt-financed deficits. As the analysis here indicates, if the first alternative is available, that of financing deficits with new money creation, this may be the most efficient policy combination under either fixed or flexible exchange rates.
[1. ]The “classic” modern works in this theory are those of Paul A. Samuelson and R. A. Musgrave. See Samuelson, “The Pure Theory of Public Expenditure,” Review of Economics and Statistics, XXXVI (November, 1954), 387-89; “Diagrammatic Exposition of a Theory of Public Expenditure,” Review of Economics and Statistics, XXXVII (November, 1955), 350-55; and Musgrave, The Theory of Public Finance (New York: McGraw-Hill, 1959).
[2. ]Wicksell’;s basic work is Finanztheoretische Untersuchungen (Jena: Gustav Fischer, 1896). The major portions of this work are translated as “A New Principle of Just Taxation,” in Classics in the Theory of Public Finance, ed. R. A. Musgrave and A. T. Peacock (London: Macmillan, 1958), pp. 72-118.
[3. ]Specifically, the reference here is to the concept of justice that is advanced in several recent papers by John Rawls. See Rawls, “Justice as Fairness,” Philosophical Review, LXVII (April, 1958), 164-94; “Constitutional Liberty and the Concept of Justice,” Nomos VI, ed. C. Friedrich and J. Chapman (New York: Atherton Press, 1963); and, somewhat earlier, “Two Concepts of Rules,” Philosophical Review, LXIV (January, 1955), 3-32.
[4. ]R. A. Musgrave, The Theory of Public Finance.
[5. ]The problem of redistribution in the setting proposed here has been discussed in somewhat more detail in James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962), especially Chapter 13.
[6. ]Cf. E. Rignano, The Social Significance of the Inheritance Tax, trans. W. J. Shultz (New York: Alfred A. Knopf, 1924).