The Online Library of Liberty

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• Foreword
• Geoffrey Brennan
• Preface
• Acknowledgments
• The Power to Tax
• 1.: Taxation In Constitutional Perspective
• 1.1.: The Notion of a “constitution”
• 1.2.: The Logic of a Constitution
• 1.3.: The Means of Constitutional Constraint
• 1.4.: The Wicksellian Ideal and Majoritarian Reality
• 1.5.: The Power to Tax
• 1.6.: The Enforceability of Constitutional Contract
• 1.7.: Normative Implications
• 2.: Natural Government a Model of Leviathan
• 2.1.: Leviathan As Actuality and As Contingency
• 2.2.: Monopoly Government and Popular Sovereignty
• 2.3.: The Model of “leviathan”: Revenue Maximization
• 2.4.: The Model of Leviathan As Monolith
• 2.5.: The Constitutional Criteria
• 3.: Constraints On Base and Rate Structure *
• 3.1.: Government As Revenue Maximizer Subject to Constitutional Tax Constraints
• 3.2.: Tax-base and Tax-rate Constraints In a Simple Model
• 3.3.: One Among Many
• 3.4.: Tax Limits and Tax Reform
• Appendix: Progression In the Multiperson Setting
• 4.: The Taxation of Commodities
• 4.1.: The Conventional Wisdom
• 4.2.: Constitutional Tax Choice
• 4.3.: Alternative Forms of Commodity Tax: the Choice of Base
• 4.4.: Uniformity of Rates Over Commodities
• 4.5.: Uniformity of Rates Over Individuals
• 4.6.: Discrimination By Means of the Rate Structure
• 4.7.: Summary
• Appendix
• 5.: Taxation Through Time Income Taxes, Capital Taxes, and Public Debt
• 5.1.: Income Taxes, Capital Taxes, and Public Debt In Orthodox Public Finance
• 5.2.: The Timing of Rate Announcement
• 5.3.: Income and Capital Taxes Under Perpetual Leviathan
• 5.4: Leviathan’s Time Preference
• 5.5.: The Time Preference of the Taxpayer-citizen With Respect to Public Spending
• 5.6.: The Power to Borrow
• 5.7.: Conclusions
• 6.: Money Creation and Taxation
• 6.1.: The Power to Create Money
• 6.2.: Inflation and the Taxation of Money Balances: a “land” Analogy
• 6.3.: Inflation and the Taxation of Money Balances
• 6.4.: Inflationary Expectations Under Leviathan
• 6.5.: Inflation, Wealth Taxation, and the Durability of Money
• 6.6.: The Orthodox Discussion of Inflation As a Tax
• 6.7.: The Monetary Constitution
• 6.8.: Inflation and Income Tax Revenue
• 6.9.: Monetary Rules and Tax Rules
• 7.: The Disposition of Public Revenues *
• 7.1.: The Model
• 7.2.: Public-goods Supply Under a Pure Surplus Maximizer: Geometric Analysis
• 7.3.: The Surplus Maximizer: Algebraic Treatment
• 7.4.: The Nonsurplus Maximizer
• 7.5.: Toward a Tax Policy
• 8.: The Domain of Politics
• 8.1.: Procedural Constraints On Political Decision Making
• 8.2.: The Rule of Law: General Rules
• 8.3.: The Domain of Public Expenditures
• 8.4.: Government By Coercion
• 9.: Open Economy, Federalism, and Taxing Authority
• 9.1.: Toward a Tax Constitution For Leviathan In an Open Economy With Trade But Without Migration
• 9.2.: Tax Rules In an Open Economy With Trade and Migration
• 9.3.: Federalism As a Component of a Fiscal Constitution
• 9.4.: An Alternative Theory of Government Grants
• 9.5.: A Tax Constitution For a Federal State
• 9.6.: Conclusions
• 10.: Toward Authentic Tax Reform Prospects and Prescriptions
• 10.1.: Taxation In Constitutional Perspective
• 10.2.: Tax Reform As Tax Limits
• 10.3.: Tax-rate Limits: the Logic of Proposition 13
• 10.4.: Tax-base Constraints
• 10.5.: Aggregate Revenue and Outlay Limits: Ratio-type Proposals For Constitutional Constraint
• 10.6.: Procedural Limits: Qualified Majorities and Budget Balance
• 10.7.: Toward Authentic Tax Reform
• Epilogue

6.9.

Monetary Rules and Tax Rules

Two separate features emerge in a consideration of monetary rules that warrant more discussion, even if that discussion is brief. The first involves the notion of “efficiency” or “optimality” in monetary rules; the second involves the underlying presuppositions about the workings of government. These features combine to suggest that, at least in some respects, the monetary-rule discussion provides a plausible lead-in or bridge to our basic model of analysis.

As the analysis of this chapter has indicated, the welfare economics of “inflation as a tax” almost necessarily draws attention to the rate of inflation through a sequence of periods. It would be analytically meaningless to refer to an “optimal” rate of inflation in a strict one-period model. “Optimality” or “efficiency” in the monetary context, therefore, must refer to a policy that embodies some multiperiod dimension.

In present-value computations, such as those embodied in the construction of Figure 6.2, the multiperiod dimensionality of the model necessarily emerges. One of the reasons for the ambiguities in the application of the Bailey-type analysis may stem from the single-period or flow model, which may have obscured the fact that the model’s relevance is limited to alternative permanent regimes. The multiperiod setting is in sharp contrast to the single-period setting assumed for most of the equi-revenue models for determining “optimality” in the allocation of tax shares. In a real sense, the discussion of monetary rules must be quasi-constitutional simply because a “rule” by its nature must remain operative over an indefinite future.

The definition of the optimal monetary rule or the optimal rate of inflation that has emerged from the welfare analysis of inflation as a tax is, however, somewhat bizarre when looked at in comparison with familiar tax norms. As enunciated most clearly by Friedman, and, as noted above, in the standard model, the “optimal” rate of inflation is the negative offset of the positive real rate of interest. If the real rate of interest in the economy is 2 percent, the “optimal” monetary rule involves deflation at 2 percent per period. The logical basis for such an attribution of optimality lies in the zero (or near-zero) cost of creating nominal money. To prevent persons from economizing uneconomically on the use of money, it is necessary that money be made available at its genuine marginal cost, defined in opportunity-cost terms as the risk-free rate of yield on assets in the economy. Only if money itself is made to yield a positive return will such efficiency in individual portfolio adjustment be ensured. To implement such a monetary rule, however, government will necessarily be required to generate budgetary surpluses sufficient to allow for the reduction in the money stock period by period.

In this setting, there is no excess burden, no efficiency loss, from the monetary sector. The full value of the “money-users’ surplus,” the value of money for transactions purposes, is captured by the users themselves. No part of this value is captured by government: government is not allowed to secure any of the rent that is implicit in possession of money-creating power.

This notion of “optimality” seems straightforward enough until it is placed alongside the standard tax analysis. In commodity taxation, for example, an equivalent “theorem” could readily be derived, and proved, to the effect that the “optimal” rate of tax for any commodity is zero. In such a case, no excess burden is generated; efficiency losses are zero; and the full rent of commodity production, under competitive conditions, accrues to consumers. And since the result can apply to any commodity taken in isolation, it must also apply to every commodity and, indeed, to any and all conceivable bases of tax. But it would mean very little to say that optimality in taxation involves zero rates on all potential bases.17

Since, by presumption of the whole analysis, government must collect some revenues, we are necessarily in a regime where some excess burden must be anticipated. Once this situation is recognized, the implicit tax on money balances that any departure from the so-called optimal monetary rule introduces is to be compared with taxes on other possible bases, and some overall optimality in taxation may then be defined. All of this follows directly from within the frame of orthodox tax analysis; this critique does not in any way depend on either our constitutional or our Leviathan perspective.

From the latter perspective, the rational selection of some monetary rule is not determinate a priori, at least not independently of the effects of taxing alternative bases and of the demands for governmentally provided services. The optimal tax on money balances cannot be determined in isolation any more than could an optimal tax on beer.

A second feature of the monetary-rule discussion concerns the implicit assumptions made about the workings of the political process. Many economists have lived with the contradiction that government can, in some way, be “trusted” to allocate tax shares benevolently in accordance with criteria for efficiency and equity, but that the same government cannot be comparably trusted to keep monetary creation within desired limits. These economists have tended to support monetary rules, as if these are to be constitutionally enforced, while they neglect tax rules and may even oppose any introduction of such constraints.18 The anomaly here may stem from the observed rates of inflation, which seem to be out of line with any model of “responsible benevolence” on the part of government and its arms and agencies. By contrast, increases in the levels of taxation beyond desired limits are less readily observable, and these intrude less directly on the consciousness of citizens.

Nonetheless, the familiar tendency to model government behavior nonbenevolently with respect to monetary policy actions does seem to offer a plausible bridge to an acceptance of the generalization of such a model offered in this book, and specifically the extension to tax actions by government. To the extent that the rules side in the “rules versus discretionary authority” debate in monetary policy circles wins adherents, the prospects for serious examination of “constitutional tax rules” in lieu of “discretionary tax policy” surely must improve.

7.

The Disposition of Public Revenues*

In the analyses of Chapters 3 through 6, we have been concerned primarily with ways in which the constitutional selection of tax institutions might be used to limit the overall level of governmental activity, the withdrawal of resources from the private sector of the economy. In order to concentrate on this aspect of constitutional fiscal choice, we assumed that the disposition of governmentally collected revenues was set exogenously, that is, independent of the tax system itself. By “disposition” here we refer to the mix between that share of revenues collected that is devoted directly to the production or provision of goods and services valued by taxpayers-consumers and that share directed to the provision of perquisites (pecuniary and nonpecuniary) to the politicians-bureaucrats. The disposition of revenues, as defined, is clearly an important element in the efficiency of the fiscal system, an element that is not necessarily less important than the level of revenues, previously analyzed.1 In this chapter, we shall focus primarily on the disposition-of-revenues issue.

The setting for analysis is the same as that introduced in preceding chapters. We are examining the choice calculus of an individual at the constitutional stage where he is confronted with a selection of tax or fiscal instruments that are to be applied throughout a sequence of periods. At this stage, the individual is presumed to be unable to predict what his own economic position will be during the relevant sequence. We presume, further, that the only controls upon the Leviathan-like proclivities of government are those that might be imposed constitutionally. Voters-taxpayers are essentially powerless to affect government’s fiscal activities in postconstitutional political settings.

Previous discussion has demonstrated how the potential taxpayer-beneficiary may seek to build constraints into the effective tax constitution that will limit the total revenue demands of government. But how may the potential taxpayer-beneficiary, at the same time, ensure that the revenues collected will be devoted to the financing of those goods and services that he values? Once given the taxing power, what is to prevent Leviathan from utilizing revenue to further its own particular purposes? At one period in history, monarchs used substantial revenues to equip and maintain lavishly appointed courts;2 in more recent times, excessive staff, high salaries, numerous perquisites, and congenial working conditions have characterized governmental establishments.

A variety of mechanisms may, of course, be conceived which might prevent undue diversion of revenues from the intended purpose of providing public services. In this chapter, however, we want to concentrate on those enforcement mechanisms that may be built into the tax structure itself. The particular virtue of tax constraints, as opposed to most of the obvious alternatives, is that they build into the very structure of Leviathan’s coercive power an automatic interest in wielding such power for the “common good”: the incentives are arranged so that the natural appetites of Leviathan are mobilized to ensure that, to a substantial degree, revenues are used as taxpayers desire them to be used. The fiscal constitution becomes, in this basic sense, self-enforcing. The central feature in such a constitution is a particular form of earmarking, which the analysis of this chapter will demonstrate.

[17. ] See Edmund S. Phelps, “Inflation in the Theory of Public Finance,” Swedish Journal of Economics, 75 (March 1973), 67-82; and Jeremy J. Siegel, “A Note on Optimal Taxation and the Optimal Rate of Inflation,” Journal of Monetary Economics, 4 (April 1978), 297-305.

[18. ] The position of Arthur Burns is in sharp contrast with that suggested here. At an American Enterprise Institute conference in mid-1979, Burns indicated support for tax or fiscal rules while holding fast to his familiar opposition to monetary rules.

[* ] We published a preliminary version of this chapter as “Tax Instruments as Constraints on the Disposition of Public Revenues,” Journal of Public Economics, 9 (June 1978), 301-18.

[1. ] A third element determining the overall efficiency of the public expenditure, over and beyond both the level and the disposition, is the composition of budgetary outlay as among separate components. We do not discuss this element explicitly, although our analysis does have implications that are relevant.

[2. ] “It was found, on one occasion, that nearly half the money that had been voted for the Dutch war had gone to the ‘corporal pleasures’ of the most religious and gracious king—see Pepys’s Diaries,ad 1666, Sept. 23 and Oct. 10.” Footnote in “Edinburgh Review and the ‘Greatest Happiness Principle,’ “ Westminster Review, 22 (October 1829). Reprinted in Utilitarian Logic and Politics, ed. Jack Lively and John Rees (Oxford: Clarendon Press, 1978), p. 184. The author of the Westminster Review essay is presumably not known.