The Online Library of Liberty

A project of Liberty Fund, Inc.

• 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

8.2.

The Rule of Law: General Rules

A different, if somewhat related, approach to that previously discussed as procedural may be examined under the rubric of the “rule of law.” This approach, perhaps best identified by the arguments of F. A. Hayek in his The Constitution of Liberty (1960) and subsequent writings, aims to restrict the structure or pattern of allowable outcomes rather than either the procedures for reaching outcomes or the specific outcomes themselves. This objective is to be accomplished by requiring that outcomes of the fiscal process conform to the familiar and time-honored “rule of law.” By this Hayek means that all rules involving taxes must be general. They must be universally applicable to all members of the political community, whether or not these persons are inside or outside the subset of persons that make the governmental decisions. This approach essentially reflects the specific application of the traditional legal norm of “equality before the law” to the taxing activities of government.

Historically, the constitutional requirement that taxes be uniform seems to stem directly from this legal norm. As our earlier analysis has indicated, tax uniformity may be generated as one means of restricting the revenue-gathering potential of government. In our analytic setting, such uniformity was taken to require nondifferentiation in tax rates among persons or among groups or among different tax bases. However, insofar as this sort of uniformity is to be found in modern fiscal systems, it probably reflects residues of the legal equality norm rather than any overt consciousness of the need to restrict Leviathan’s fiscal appetite. The tenuousness of existing uniformity precepts is evident; taxes do and may vary among persons and among groups; different tax bases are subjected to differing levies. At best, existing legal norms, as currently interpreted, serve only to rule out totally arbitrary discrimination in taxation. For example, the United States government could not (or at least has not, to date, been able to) impose one rate of income tax on Catholics and another rate on Protestants, one rate on blacks and another rate on whites, one rate on women and another rate on men. If the government tried any such tax discrimination, it seems likely that it would be ruled out of court on constitutional grounds. Of course, were government able to discriminate beyond currently allowable limits, it could generate more revenues from its current sources, as our analysis in Chapter 4 indicated. The accepted legal norms do, therefore, limit Leviathan. The taxing power is not unrestricted.1

This Hayekian interpretation of the rule of law as requiring generalized uniformity suggests two questions. How effective are existing legal limits? And how could a generalized extension of the legal norm of uniformity be used so as to constrain Leviathan beyond those limits already discussed?

These questions immediately raise issues of definition. How is uniformity or equality to be defined for tax purposes? Should “equality before the law” in taxation require equal payments by all persons in the polity? Or should such equality be interpreted to require that all persons in the jurisdiction confront equal rates of tax, hence allowing for proportional but not regressive or progressive tax structures? Hayek’s argument to the effect that a proportional tax structure would meet the requirement for generality whereas a progressive rate structure would not do so seems to be dangerously arbitrary. To defend such a position requires considerably more analysis than Hayek has provided.

If we leave the questions of definition aside, however, does the generality requirement impose checks on the taxing proclivity of Leviathan? Would the stipulation that persons who are inside the ruling coalition face the same tax structure as those who remain outside the ruling coalition restrict the taxing power as such? With no accompanying constraints, would the mere fact that members of the ruling group themselves pay taxes like everyone else effectively result in less total tax gathering?

It seems clear that it would, at least in some plausible settings. Consider a simple example in which Leviathan takes the form of an exploitative majority coalition. Suppose further that the uniformity requirement on the tax side involves the requirement that revenues be raised by a completely general income tax. To avoid definitional questions of the type indicated above, suppose that all citizens-taxpayers have identical tastes and pretax incomes, so that the choice between progression and proportionality involves no question of discrimination between individuals. Given here that the majority and minority are of virtually identical size, the contribution that members of the majority make to each dollar of revenue collected is virtually 50 cents. It may therefore seem as if the majority would rationally vote for maximum revenue: it makes a net gain of almost 50 cents for every dollar of revenue collected. This conclusion would be valid if taxes were lump-sum. Uniformity in and of itself—specifically in the absence of any restrictions on the power to tax—would not limit Leviathan at all: the exploitative majority would end up with all the income. In the presence of base limits of the sort we have analyzed earlier, however, the uniformity requirement does serve as an additional means of constraint. For where the tax to be levied involves limited revenue, it also involves an excess burden for all taxpayers. This excess burden is present because each of the taxpayers, including those in the majority coalition, will rationally attempt to minimize his own tax payment by substituting away from the taxed good. At some level, the marginal excess burden sustained by members of the majority coalition will be equal to the marginal transfer received from members of the minority. The majority coalition will not seek to push the extent of redistribution beyond this point, because they lose more in additional excess burden from the tax system per dollar of additional transfer received than they gain in transfers.

Consider a simple example. The tax base is taken to be money income, X, leaving leisure exempt. The “demand” curve for X for the economy as a whole is depicted as the D curve in Figure 8.1. Given the assumption of identical tastes, this “demand” for X can be divided into two (virtually) identical parts, with D_m being the aggregate demand for X over all members of the majority coalition. With uniform taxes, the most revenue that can be obtained from the taxation of X is shown by the shaded areas, R*, in Figure 8.1: one-half of this revenue (or one-half of any other quantity of revenue, for that matter) will be paid by members of the majority coalition. The welfare loss sustained by taxpayers at this maximal level of revenue will, in the linear case, be precisely one-half the maximum revenue yield (as demonstrated in Chapters 3 and 4).

We can transfer the information in Figure 8.1 into a more usable form by depicting in Figure 8.2 the costs to majority members of any transfers they receive. Such costs are of two parts: first, since taxes are uniform and the majority is a bare 50 percent of the population, majority members pay in taxes 50 cents out of every dollar of transfer revenue. This is shown as the horizontal line at 50 cents in Figure 8.2. Beyond this, however, there is the excess burden of the tax system. One-half of this excess burden, also, will be borne by the decisive majority. To determine total marginal costs to the majority, including excess burden, of higher transfer levels, we need to add to the 50-cent line in Figure 8.2 the marginal excess burden per dollar of revenue raised. Clearly, the addition to welfare cost or excess burden associated with an extra dollar of revenue approaches infinity as revenue approaches its maximum. For as the tax rate approaches the revenue-maximizing rate t*, the excess burden is increasing at an increasing rate while the revenue level is increasing at a decreasing rate. For tax-rate increases in the neighborhood of t*, excess burden rises while the revenue increase is zero: the extra welfare loss associated with an additional dollar of transfers (or an additional dollar of revenue) is quite literally infinite.

On this basis, we can draw from the 50-cent line upward a curve labeled TMC in Figure 8.2 that depicts the total marginal cost to majority members of various levels of transfer, including that part of the excess burden of the tax system that majority members bear. At R*, the TMC curve will approach infinity, indicating that the excess burden per dollar of extra revenue is approaching infinity. The area between TMC and the 50-cent line up to R* measures the total excess burden of R* borne by majority members: since the majority is one-half of the electorate, this will be one-half of aggregate excess burden, or ½ W* in Figure 8.1.

Given TMC, we are in a position to predict the level of transfers that the decisive majority will rationally vote for. Since the value of a dollar transfer to the majority is always $1, the level of transfers emergent under majority rule will occur where the TMC curve intersects the $1 line. At this point, the cost of an extra dollar’s transfer, including the excess burden of taxes that the majority pays, is exactly $1. We depict this point by R_m in Figure 8.2. Clearly, R_m will be to the left of R*: the majority will not push taxes to the revenue-maximizing limit. The revenue level R_m depicts the total revenue raised for transfers in the presence of a generality requirement on the tax side.

Let us now suppose that the generality requirement does not apply. The majority will now apply taxes to the minority alone, and will do so up to the revenue-maximizing limit. Since the minority is one-half the population, revenue will be ½ R*; and the majority will receive all that revenue in transfers. The excess burden sustained by minority members will be one-half of this maximum revenue, or ¼ R*, given linearity assumptions.

The implications of the generality requirement for a given tax base can now be gauged by appeal to a direct comparison of the two equilibria. In the absence of generality: aggregate tax revenue is ½ R* dollars; the net benefit of transfers to the majority coalition is ½ R* dollars; and total excess burden is ¼ R*. In the presence of the tax generality requirement: aggregate tax revenue is R_m; the net benefit of transfers to the majority coalition is the area between TMC and the $1 line up to R_m in Figure 8.2; and total excess burden is twice the area between TMC and the 50-cent line up to R_m in Figure 8.2. Since R_m is less than R*, and the benefits to majority members in the generality case are less than ½ R_m, those benefits are also less than ½ R*. Majority members lose by the generality constraint. In the case of general taxation, however, both majority and minority members sustain excess burdens due to taxation, and the total excess burden in this case may exceed that in which only minority members pay taxes. In sum, the generality requirement clearly reduces the fiscal exploitation of the minority, but it will increase total tax revenue and it may increase the aggregate excess burden attributable to taxation. The net effects of the generality rule on the tax side are therefore not entirely unambiguous.

The model outlined here in some sense makes the case for the effectiveness of uniformity constraints in its most generous form. As the size of the decisive coalition falls from one-half of the electorate to an even smaller proportion of the citizenry—to a ruling class, a bureaucratic elite, a president-premier-king—the bite of any uniformity constraint falls: the contribution of the decision makers to the cost of transfers to themselves becomes smaller and smaller. In terms of Figure 8.2, a reduction in the size of the dominant or ruling coalition would have the effect of displacing the TMC curve downward throughout its range, and hence shifting the solution toward R*.

In the discussion of this section, we have set aside the possibility that the Leviathan surplus should itself be subject to tax. Although this is not inconceivable in the case of the exploitative majority, it becomes rather strained where the transfers take the form of public expenditures of particular benefit to the ruling class or the bureaucratic elite.

[1. ] For a general discussion of the fiscal constitution, see Kenneth W. Dam, “The American Fiscal Constitution,” University of Chicago Law Review, 44 (Winter 1977), 271-320.