The Wealth of Nations: Book 5, Chapter 2 Summary & Analysis

A government funded by the profits from commerce or moneylending could collapse in times of economic crisis. In contrast, one that relies on rents will only decline, because land will never lose all of its value. As Smith points out, feudal states relied on rents, but this is part of why they were so inefficient and economically stagnant. Just like joint-stock companies perform poorly because their owners don’t have a direct stake in their success, he argues, state-owned land performs poorly because the people who manage it don’t benefit when its value rises. This is why it's more efficient to give the land to private individuals, then tax them. As they improve it, the government will always get a slice of the value they add.

Having explained why profits, rents, and fees are typically inadequate and unreliable ways to fund the government, Smith turns to this chapter’s primary subject: taxes. He begins with this breakdown of the kinds of taxes and the principles behind them because not all taxes are created equal. The government can choose to tax any part of the economy that it pleases, but all such taxes change the incentives for people’s economic behavior. In the worst cases, a tax can actually undermine the very sector of the economy from which it hopes to derive its revenue. But in the best cases, wise tax policy can encourage good financial decisions and boost the economy, just like the forms of public investment that Smith described in the last chapter. The principles of proportionality, predictability, convenience, and reasonableness all ensure that the tax system will disrupt the economy (and offend citizens) as little as possible.

A constant land tax means that everyone pays the same tax, year after year, based solely on the amount of land they own. Taxing all land the same might seem simple and efficient, but it is deeply unfair and shortsighted because it ignores many important economic realities. Specifically, it is unfair because different kinds of land inherently have different levels of economic value, and it is shortsighted because it prevents the government from sharing in the productivity gains from improved land. This kind of land tax helps landlords because, while their land’s value, rent, and productivity increase year after year, their taxes do not. Accordingly, these taxes become less and less significant to the landlord over time.

Rent is already proportional to the value of land, so it serves as a good proxy for calculating the value of a fair land tax. Charging lease renewal fees and asking for rent in rude produce are both ways that landlords would try to circumvent the tax, by reporting less rent to the government than their tenants actually pay. The agricultural economy does best if farmers can cultivate the land however they want, which maximizes their income. This is why Smith believes landlords should be punished if they try to make those decisions for the farmers. And people who farm their own land not only have a greater incentive to improve it, but also get to keep more of their revenue as a surplus (and convert it to capital) because they don’t have to pay rent.

The way a land tax is administered can shape its effectiveness almost as much as the way it’s calculated. Smith prefers registries to land surveys because they are far cheaper and don’t need to be redone every few years. And exempting the church or nobility from taxes as a political favor only enriches them further, entrenches their power, and reduces their incentive to improve their land. Smith supports instead taxing them at higher rates, in order to erode their political and economic power.

Taxes on rude produce are really land taxes because farmers pass the cost along to landlords, by reducing the rent they’re willing to pay. Rude produce makes up a farmer’s revenue, but their rent depends on what they can afford to pay after subtracting their expenses. Thus, the difference between taxing rude produce and taxing rent is just like the difference between taxing a company’s revenue and taxing its profits. Companies that operate on thin profit margins suffer much more from a revenue tax, while a tax on profits affects all companies equally. This is why Smith categorically opposes taxes on rude produce.

Taxes on rude produce are easy in theory: the farmer just gives away a portion of their harvest every year. There is no need for land surveys, rent registries, or complex calculations. But in practice, they require the state to collect, measure, transport, and redistribute or sell a massive amount of bulky, often perishable produce. And even if they’re recalculated and assessed in money every year, they’re still simply less efficient than taxes proportional to rent.

Ground rent explains why the exact same house on the same lot would rent for much more in the city than in the countryside. House rent taxes specifically affect ground rent because they don’t go to the builder, but just make the land more expensive. In Smith’s time, raising rents across the board through house taxes didn’t seem unreasonable, as the wealthy tended to live in the city or in extravagant country manors, while the poor mostly lived on farms or rented rooms. Of course, the class dynamics of rent have largely switched since the 18th century: the poor are now more rent-burdened than the rich. This means that applying Smith’s principle of fair taxation would now lead us to reject house taxes.

Land is a productive asset because farming it generates rude produce (and revenue), so in this way it can pay its own rent. Houses are typically unproductive because they don’t generate revenue for the occupant. In fact, they occupy land that could be used for farming instead. And the more someone spends on rent, the less they have left over to save, invest, or spend on productive labor—so it’s better for the economy if people live well within their means, rather than renting extravagant houses. Ultimately, the principle behind taxing the ground rent for houses is the same as for the rent for farmland. It’s simply the easiest, fairest system. Smith’s point about house taxes reflecting the value the government has added to the land is key: land values are a function of the whole local economy’s health, because they reflect the value of the opportunity to live and do business in an area. The security and economic environment provided by the government is directly responsible for raising them, and so nobody can reasonably claim house taxes to be unjust.

England’s house tax system used all kinds of inaccurate proxies for home values, rather than assessing them proportionately based on rents. It may seem counterintuitive that taxes lower rents rather than raising them. The key to understanding this dynamic is the principle that rents are based on what people are willing to pay, not on any real underlying value. Accordingly, taxes don’t change the total amount that a tenant can afford to pay, but rather just obligate them to give a portion of that total as a tax.

Society’s revenue is divided into rents, profits, and wages. Smith has explained how the government can tax rents, and now he will turn to profits, and then finally to wages. Profit is broken down into two parts because a company that borrows capital for its operations always has to pay back interest (and anyone who invests their own capital must earn at least the ordinary rate of interest for it to have been worth their while). Whether taxes on profits will lower interest rates or simply eat into a company’s returns depends in part on how widely they are applied. If everyone faces the same tax, then money lenders may be left with no choice but to lower interest rates (or lend money abroad, if this helps them avoid the tax).

Taxes on interest are one example of a tax that is just, but simply too complicated to implement. In Smith’s time, this would have required procuring and going through every individual and company’s financial records in detail—if they even keep them. Of course, these calculations are all much simpler today. The comparison between taxing interest and the English land tax shows that, when a tax is invasive or controversial, people will only accept it if it’s very low. And so it will inevitably fail to collect much revenue.

Taxing private people’s wealth is so administratively complex that Europe’s richest commercial city-states opt for an honor system—and assess these taxes at very low rates. Of course, people’s willingness to declare their wealth and pay these taxes at all suggests that they trust their governments. And since these city-states’ economies depend mainly on commerce, most of their capital is held in merchants’ private fortunes—and so they seek most of their revenue from the same source.

The government may choose to selectively tax certain industries, whether because it considers them harmful to the public, because they use additional public resources, or because they are particularly profitable. But one-time fees would encourage monopolistic behavior by creating barriers to entry for small firms. Again, the measurement issues that Smith describes have largely been solved, and today taxes on specific industries are common (although, as Smith will soon point out, it’s often easier to just tax the commodities used in them instead).

France’s agricultural profit tax was designed to be proportional, but it failed because even the best professional estimates could not accurately predict how much people should actually owe. Worse still, these estimates assume that farmers who invest in better tools will earn higher profits, so they face higher tax bills—which discourages them from actually making improvements. So even if taxing profits is far better than just taxing revenue in agriculture, France’s policy still doesn’t succeed. This again shows how, when it comes to taxation, good intentions are nothing without good policy design.

Smith isn’t saying that enslaved people should be treated as property—he has already made it clear that he opposes slavery on both moral and economic grounds. Rather, he’s saying that, if the law chooses to treat them as property, it also has the right to tax them as property. Indeed, taxes on enslavers should discourage slavery, and taxes on people who employ menial servants should discourage them from doing so (which Smith considers beneficial because menial servants are unproductive laborers). His note about how taxes affect interest rates underlines how the government can tax particular industries in order to put them at a disadvantage: they will still have to borrow money at the same interest rate as everyone else, so they must make a higher profit margin than other industries to still be worth their while.

Once again, Smith’s argument for a particular kind of tax depends primarily on the ease of administering it. But taxing property transfers is also reasonable because they rely on the state’s guarantee of secure property rights. For instance, if someone squats in Smith’s house while he is in the process of selling it to someone else, he needs the state to formally recognize his ownership, the legitimacy of the sale, and his buyer’s new ownership in order for them to reclaim the house. Only the state can adjudicate this kind of dispute, and so it can reasonably require people to pay fees in exchange for guaranteeing the security of their transfer.

Smith clears up a series of minor confusions about tax policy. While modern readers may find it tedious, they must also recall that Smith’s purpose was to help his contemporaries improve their policies, and this meant outlining how to levy taxes in the greatest detail he could muster. There is a clear rationale behind each of his points. Inheritance taxes fall on the heirs because they simply end up receiving less than the total value of the estate left to them. Land and property sale taxes fall on the sellers in much the same way: the buyer pays the property’s fair market value, and then any taxes get subtracted from it before it reaches the seller. Borrowers end up covering loan fees because lenders still have to earn the same standard interest rate, so any fees just get added on top. Public property registers eliminate any doubt about ownership in the case of disputes. And even if transfer taxes disadvantage people who repeatedly transfer their property, they are still clear and predictable. Moreover, if these taxes deter property owners from making a living by speculating on property, it will push them towards more productive kinds of investment instead.

Wage taxes are relatively common around the world today. Since the vast majority of people earn their money from work, rather than rent or investments, wage taxes have broad effects on prices and the economy. But they also raise quite a lot of revenue and don’t risk suddenly drying up during times of economic hardship. Once again, the fact that interest and rent are market prices determines who bears the true burden for taxation—and yet they have opposite effects. Investors must get their standard interest rate, so employers must raise prices to cover the cost of wage taxes. But rents depend not on what landlords want to charge but on what farmers can afford to pay, so if taxes increase their expenses across the board, rents will fall across the board, too.

Rather than taxing people based on the way they make their money—through profit, rent, or wages—another approach is to tax them based on what they buy, what they own, or simply whether they live within a country in a given year. The first kind are taxes on consumable commodities, and the other two are both forms of capitation taxes.

Historically, many capitation taxes simply require everyone to pay the same amount, which makes them regressive and deeply unfair to the poor. Smith focuses more on wealth taxes and rank-based taxes (for instance, taxes levied only on farmers, clergymen, or the nobility). He generally opposes wealth-based capitation taxes for the same reason as he rejects taxes on interest. Since they are so difficult to measure and administer, they are very unfair. Since they are so unfair, they have to be very low. And since they are so low, they don’t actually collect much revenue. But once again, the measurement difficulties that plagued tax administrators in Smith’s day are no longer a problem, and wealth taxes are common around the world today.

Sales taxes are almost universal around the world today, for the same reason that Smith cites here: they are easier to administer than taxes on revenue. Indeed, countries with large informal workforces largely rely on sales taxes today. They reach everyone in the economy, regardless of their income source.

Different principles apply to taxing necessities and luxuries, since everyone has to buy necessities, while luxuries are always a choice. Smith’s disdain for the poor who waste money on luxuries may have been typical of 18th century England—and may not apply to a modern context with lower infant mortality—but he clearly thought that taxing luxuries only hurt people who deserved it anyways.

Smith applies the principles of supply and demand to demography. He isn’t suggesting that the government should make conditions worse for the poor so that they have fewer children, nor necessarily that it should try to make their lives easier so that they have more. Rather, he’s just pointing out how the cost of subsistence and wage level affect people’s family planning decisions, which can have long-term impacts on a nation’s economic structure. Higher wages lower rent because farmers have less money left over for it after paying wages, and they increase the price of manufactured goods by increasing the cost to produce them. Of course, once these wages adjust up to the new cost of subsistence, poor laborers may be just as well off as before—and start having children again.

Today, governments typically use neither of these systems. Instead, they tax consumers directly at the point of sale when they buy goods. Taxing merchants when they take in an inventory of perishable goods makes sense, because they will have to sell all those goods in a specific timeframe. And one-time annual licensing fees make sense for luxuries that few people buy and use consistently. But something like alcohol should be taxed based on the amount someone consumes, not on the fact that they consume at all. Indeed, a licensing fee for alcohol would make it cheaper the more one drinks.

In the remainder of this chapter, Smith will bring his discussion of commodity taxes together with his analysis of international trade from Book IV in order to offer a series of more specific recommendations for Britain’s tax policy. The first two iterations of its tax system, which he outlines here, are actually much closer to his proposals than the system that was in place in 1776.

Mercantilism led Britain to start subsidizing exports instead of taxing them. Meanwhile, it taxed imports based on the extent to which British manufacturers wanted them, assessing zero or low taxes on goods they needed and high taxes on goods that competed with what they produced. This may have supported the balance of trade and greatly enriched merchants and manufacturers, but it didn’t necessarily support economic growth overall, and it certainly didn’t reduce prices for consumers. And above all, Smith’s main complaint about this system is simply its complexity and inefficiency.

Smith’s recommendations are based on the combination of three principles. First, taxes should be simple, so that administering them is cheap. Second, they should not harm overall economic growth by discouraging consumption. And third and finally, they should actually collect revenue for the government. A well-designed import tax system will do all three, and Smith emphasizes that Britain can achieve this without disadvantaging its manufacturers. Notably, none of the goods he supports taxing can actually be produced in Britain.

Through the combination of a simplified tax system that affects fewer goods and a warehousing system that ensures all merchants actually pay their taxes, Britain could collect more customs revenue with less effort. But Smith implies that this would be difficult to achieve politically, likely because of merchants’ entrenched political power. But if they understood free trade instead of blindly following the mercantile system out of short-term self-interest, they would understand that free trade would actually enrich them in the long run by increasing the overall volume of trade.

Taxing Britain’s poor majority might earn the government significant revenue, but it would also backfire by raising prices and wages enough to affect the whole economy. This could erode the very tax base from which it drew, and it would certainly make life needlessly difficult for poor people. Once again, Smith concludes that taxing luxuries is inherently fairer, because people who buy them have disposable income, are choosing to spend it on things they do not need, and they can accordingly afford to pay extra taxes.

The tax exemption for private brewing and distilling allows Britain’s richest people to avoid paying taxes on the single largest form of luxury consumption. Smith’s proposal to tax malt, a key ingredient in brewing, would put everyone on the same footing and greatly simplify the tax system. Smith’s belief in the health benefits of beer may no longer strike us as common sense, but many nations around the world still tax liquor heavily in an attempt to deter consumption.

Even if producers pass the cost of consumption taxes on to customers, these taxes naturally harm producers by raising prices and decreasing demand for their products. Yet with Smith’s malt tax proposal, the overall tax burden on maltsters’ products would actually decrease. Malt is typically made of barley. Barley land’s convertibility to other uses means that, if prices fall, so will production, and it will stay around the same equilibrium price—like any other commodity in a competitive market. The same doesn’t apply to wine or sugar because they can’t easily be converted, so shifts in demand won’t alter the supply.

The taxes that Smith describes here are reasonable in the era before strong centralized states. But once it becomes possible to just tax goods once, that is usually preferable because the cost of administrating taxes has little to do with the tax rate. Rather, the fewer times a commodity gets taxed, the more efficient the system. For instance, taxing goods once at 20% costs half as much as taxing them twice at 10%.

Earlier in this chapter, Smith laid out four criteria for well-designed taxes: they should be fair, predictable, convenient, and no higher than necessary. Here, he outlines why taxes on luxuries clearly meet the first three criteria. Today, lawmakers clearly still agree with Smith: luxury goods, and particularly socially harmful ones like tobacco, face some of the highest taxes of any goods.

All taxes are inefficient to some extent, because they interrupt the ordinary workings of supply and demand. Commodity taxes always increase commodities’ prices above their natural level, so they cause demand for the taxed good to fall. But the effect is minimal for necessities, which people will not forego so long as they can afford them, and much stronger for luxuries. But these disadvantages don’t necessarily negate the commodity tax’s benefits. Indeed, the extent to which they do will vary depending on the exact good and market.

Just like with its relatively free trade system, Britain’s tax system was far from perfect in the 18th century, but still excellent compared to its peers’ systems. It may not have been fairer or less burdensome, but as Smith emphasizes here, its uniformity made it predictable and convenient. Beyond keeping down administrative costs, this system encouraged trade and ensured that Britain’s whole domestic market could generally access the same foreign goods.

As a general principle, Smith opposes giving private interests power over public functions. Tax farming is just another example of how businesspeople build political influence, use that influence to establish monopolies, and then use those monopolies to enrich themselves at the public expense. Middlemen aren’t always a bad thing—for instance, Smith has already noted that the grain trade can conceivably function without wholesalers, but without them it is significantly less efficient. But when any middleman gets a monopoly over their trade, such that all goods have to go through their hands, they inevitably misuse this power. (Technically, this is called a monopsony.)

Smith’s analysis of England’s two closest peers, France and Holland, shows how each country’s specific political history led its tax policies astray. As a result of its powerful landed nobility, France’s tax system was still inefficient and slanted toward the rich—although this would all change just over a decade later, thanks to French Revolution. And Holland’s system of high taxes helps explain its overwhelming economic focus on trade. But the factors that drove it to accept this system—its overseas wars and the land reclamation it used to build port cities—were also the result of its commercial ambitions. In this way, tax policy often contributes to path-dependence, as elites use it to protect their own wealth, power, and status.