Previous
Book 5, Chapter 1
Themes
Key
LitCharts assigns a color and icon to each theme in The Wealth of Nations, which you can use to track the themes throughout the work.
Labor, Markets, and Growth
Capital Accumulation and Investment
Institutions and Good Governance
Mercantilism and Free Trade
Money and Banking
Summary
Analysis
The sovereign can gain income from any property it owns, and by taxing the people.
Governments can earn the revenue they need to operate in several ways. Taxes are the most common and most desirable option, but not the only one. In the last chapter, Smith noted how governments can earn money from charging fees and tolls, and he will start this one by explaining how they can earn profits from their investments and rent from their land holdings. Lastly, in his final chapter, he will explore how some governments also borrow money—a practice that was relatively new when he was writing in the 18th century, but which is universal today.
Themes
“Part I. Of the Funds or Sources of Revenue which may peculiarly belong to the Sovereign or Commonwealth.” The sovereign can own stock, which it can lend or invest. In tribal herding societies, like the Tartars (Turks) or Arabs, the sovereign’s stock consists of the chief’s herds, and its revenue is the profit those herds generate (as they multiply and yield milk). In mercantile republics like Hamburg, Venice, and Amsterdam, the sovereign’s revenue can come mostly from profits on trade, banking, and post offices. Princes generally make poor merchants because they have poor business sense. Indeed, merchants also make poor sovereigns, as the East India Company’s financial troubles show.
Like any capital owner, the state can derive revenue from investing its stock in any number of ways—which will produce different returns, depending on the structure of the economy. Tribal herders and modern commercial republics are similar because they both essentially run their governments as businesses and use those businesses’ profits to pay for administration, justice, defense, and so on. But Smith again warns the reader about merchants’ natural incentive to establish monopolies—concretely, if self-interested merchants run the government, they can use it to crush free competition, raise prices while lowering quality, and enrich themselves at the people’s expense.
Themes
Sovereigns can also earn interest by lending money and treasure. The Swiss canton of Berne lends money to other states, while Hamburg runs a public pawn shop and Pennsylvania issues paper credit similar to banknotes, using land as collateral. But stock and credit are too “unstable and perishable” to fund a government long-term.
Moneylending is always an option for anyone with capital, and the state is no exception. Paper money that isn’t backed by gold—like Pennsylvania’s, or all modern states’—is essentially just a loan. In fact, most states now fund themselves by borrowing money and lending money to their citizens.
Themes
Land is comparatively secure, and so most advanced countries fund the sovereign primarily through land rents. In ancient Greece, ancient Rome, and feudal Europe, large, landed estates could cover the sovereign’s costs. This is because most people were trained soldiers, so the sovereign’s main expense—war—was cheap. But in modern European countries, land taxes cannot cover the sovereign’s expenses. Britain’s land tax applies to all land, houses, and interest earned on capital stock, but it still doesn’t cover the state’s revenue. As private people manage land better than the state, the more land the crown manages, the less it will earn in land taxes and the less the land will produce. Thus, Europe’s monarchies should sell most of the lands they own, except for parks.
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.
Themes
Get the entire The Wealth of Nations LitChart as a printable PDF.
“Part II. Of Taxes.” In most cases, the sovereign’s general revenue must come primarily from taxes. It can tax rents, profits, wages, or all three. Four key principles apply to all four kinds of taxes. First, taxes should be equal—people should pay proportionately to their revenue. Second, taxes should be clearly defined in advance so they are certain, not arbitrary. Third, taxes should be paid when it’s most convenient, so sales taxes should be charged when people buy goods, rent taxes when they pay rent, and so on. Fourth, people should be taxed no more than is necessary, and the tax system should not burden them with further costs. For instance, taxes may prove expensive to collect, suppress certain kinds of business, encourage smuggling and tax evasion (and bankrupt lawbreakers who get caught), and waste people’s time.
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.
Themes
“Article I. Taxes upon Rent. Taxes upon the Rent of Land.” Land can be taxed at a constant value, or in proportion to its real value. Constant land taxes, like the one in Britain, lead to inequality because some land gets improved, and some does not. Such taxes are easy to collect, and Britain’s has enriched the country’s landlords (but deprived the sovereign of revenue) because rents have risen significantly, while silver prices haven’t. So constant land taxes can have unpredictable effects, depending on other economic factors.
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.
Themes
French economists argue that the fairest tax is one proportional to the land rent. For instance, Venice taxes all land at 10% of its rent (or 8% for farmers who cultivate their own land). This is more equal than a constant land tax, but it requires more complex administration. Landlords and tenants should register their leases with the government, and landlords should be taxed more if they charge lease renewal fees instead of increasing the rent, try to specify how their land should be cultivated, or make tenants pay rent in rude produce. Tax breaks should encourage landlords to cultivate their own land, like in Venice. With these changes, a variable tax system would not be very expensive to administer, and it would encourage people to improve their lands (although they should not have to pay taxes on those improvements for the first few years).
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.
Themes
Proportional land taxes can adapt to changes in land improvement, the economy, and silver prices. Different countries have administered them in diverse ways. Prussia, Silesia, and Bohemia actually conducted land surveys for their rent taxes. Prussia rightly charges the church a higher tax rate, because it doesn’t improve its land, but many states charge it less. Silesia reasonably taxes the nobility higher, but Sardinia and some parts of France don’t tax the nobility at all. Montauban had to impose additional taxes because its land survey valuations quickly became outdated.
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.
Themes
“Taxes which are proportioned, not to the Rent, but to the Produce of Land.” Proportional taxes payable in rude produce, like the church’s tithe, may look like income taxes on farmers, but they’re really land taxes on landlords. Farmers always predict them in advance and factor them into the following year’s harvest. Such taxes are very unequal, as some lands produce a much larger surplus than others and should have much higher rents as a result. Put differently, 10% of a fertile land’s rude produce might only be a fifth of the landlord’s rent, while 10% of a barren land’s produce could be most of their rent. Such taxes discourage landlords from improving their lands and farmers from cultivating them well.
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.
Themes
Historically, China, Bengal, and Egypt imposed such taxes, which gave the state an incentive to build infrastructure. But tithes in Europe don’t have this benefit, as the church’s lands are small and dispersed. Collecting these taxes in rude produce is inconvenient and leads to fraud, so it’s better to collect them in money, depending on the market price of rude produce in any given year. If the price is instead fixed from year to year, these taxes become no different from constant land taxes, like Britain’s.
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.
Themes
“Taxes upon the Rent of Houses.” House rent has two parts. Building rent pays for the cost of the construction, plus the ordinary rate of interest (so that the builder can make a profit). Ground rent pays for the cost of the land. Ground rent is higher wherever there is more demand, like in cities. In the countryside, ground rent is usually whatever the land would yield if it were instead used as farmland. Taxes on house rent don’t affect the cost of building, so they ultimately increase the ground rent, which affects both tenants and landlords. They reduce competition for houses at higher rents but increase it at the lowest rents. Since the rich spend more of their income on rent than the poor (who mostly spend it on food), house rents disproportionately affect the rich. But this is reasonable, as the rich can afford to pay more.
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.
Themes
Unlike land, houses are not productive, so people have to pay taxes on house rent from their other income sources. High house rent taxes would also encourage people to spend their money more productively. Like land rent taxes, house rent taxes can be assessed based on the market rent (including for owner-occupied houses). Ground rent is the best rent to tax, as landlords do not actively use their lands, a uniform tax will not change their propensity to rent it out, and the sovereign can reasonably take credit for certain lands becoming desirable places to live (and yielding high ground rents). European countries haven’t yet singled out the ground rent for taxation, but they should.
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.
Themes
England applies its land rent tax to houses, too, but its valuations are very unfair. Holland taxes houses based on their value for sale, not rent. But this is difficult to calculate. England long taxed houses based on the number of hearths or windows instead, but this is unfair to the poor because it doesn’t account for the much higher property values in major cities like London. All taxes on houses lower rents, because the more someone pays in taxes, the less they can afford in rent.
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.
Themes
“Article II. Taxes upon Profit, or upon the Revenue arising from Stock.” Profit has two parts. One part is interest, which pays back the stockowner’s investment at an ordinary profit rate. The other part is the surplus earned in exchange for employing the capital. Taxes on profits force employers to either raise their profit rates or pay less in interest, and they pass these costs on to either farmers (if they’re investing in land) or consumers (if they’re manufacturers).
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).
Themes
Taxing interest may seem advantageous, because interest is like ground rent: it is a market price which taxation will not change. (Rather, taxes effectively deduct a portion of the investor or landlord’s earnings.) But taxing interest is actually a mistake, because calculating interest earnings is very difficult and invasive, and people may take their capital stock out of the country to avoid taxes. Countries that have tried to tax stock revenues have done so at very low, approximate rates—which is similar to how England has implemented its land 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.
Themes
No country has seriously inquired into its citizens’ private wealth in order to assess taxes. Hamburg asks citizens to pay 0.25% of their wealth annually in taxes on an honor system. In some parts of Switzerland, they also publicly declare their net worth. These small annual taxes are all meant to be taxes on interest. Holland once assessed a one-time 2% tax on net worth after establishing a new government—which was meant to be a tax on capital.
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.
Themes
“Taxes upon the Profit of particular Employments.” Some countries impose special taxes on certain occupations, like street hawkers and pubs. Businesses always pass these costs on to consumers. These taxes are fairest when proportional to profits, and they hurt smaller businesses if they are one-time licensing fees. Britain abandoned plans to tax shops because it would have been impossible to measure their business, but unfair to tax them all equally.
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).
Themes
France does tax the profits of agricultural stock. Historically, it taxed common people who owned land but not nobles, who were too powerful and refused to pay. Now, in the 18th century, it recalculates people’s tax liabilities every year, depending on a council’s assessment of regional variations in land, harvest quality, people’s ability to pay, and other relevant conditions. These assessments are never accurate. More often, they’re biased and unpredictable. Farmers won’t reasonably under-cultivate their lands or pass costs onto consumers, so this tax just reduces land rents, passing the cost on to landlords. However, since the tax is based on the capital invested in agriculture, farmers do try to appear as poor as possible by working with cheap hand tools instead of animals or finer tools.
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.
Themes
In North America and the West Indies, the colonial governments assess “poll-taxes” on planters for every person they enslave. These taxes reflect the planters’ status as citizens, while the people they enslave are their property. Thus, these taxes are reasonable. They would be unfair if assessed on free laborers. Britain and Holland’s taxes on menial servants are similar, and they primarily affect middle-ranking people who keep servants. All these taxes on particular businesses do not affect interest rates, since merchants in these businesses still buy credit in the same market with people in other businesses, who are not subject to the taxes. (But taxes on all businesses do affect interest rates.)
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.
Themes
“Appendix to Articles I and II. Taxes upon the Capital Value of Land, Houses, and Stock.” Taxes on the transfer (sale or inheritance) of land and real estate are easy to assess because these transactions are difficult to hide from the public. The transfer of capital and movable property is harder to tax, since it can be secret. The best solution is to require the payment of stamp-duties and registration fees in exchange for deeds of sale to be valid. The Romans imposed an inheritance tax, the Dutch still do, and European monarchies imposed complex property transfer taxes in the feudal era. Britain’s transfer taxes aren’t proportional to property value, while only some of Holland’s are. In France, different agencies collect the stamp-duties and the registration fees.
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.
Themes
Inheritance taxes fall on the heirs, while land and property sale taxes fall on sellers (except taxes on new buildings, which fall on buyers). Borrowers cover the registration and stamp fees for loans, while both parties do for lawsuits. All these transfer taxes harm the national revenue, as they increase the state’s revenue by taking away capital stock that would otherwise be invested in productive labor. Transfer taxes are unequal, since some people transfer property more often than others, but they are very easy to assess. The French complain endlessly about their unfair property registration system, but not their stamp-duties. Property sale registers are very beneficial because they give security to buyers, sellers, and the public alike. But these registers cannot be secret, or else officials will abuse them. Finally, stamp-duties on products like newspaper and liquor are really consumption taxes.
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.
Themes
“Article III. Taxes upon the Wages of Labour.” All production requires labor, so a tax on wages increases the price of everything. This means wages must rise not only by the amount of the tax, but also by a bit more, to cover these higher prices. Employers pass higher labor costs on to consumers in the form of higher prices, while farmers pass them on to landlords in the form of lower rents. In manufacturing, such taxes deter hiring, harm industry, and reduce the nation’s annual produce. Yet countries like France and Bohemia still assess them. Taxing government workers is a more reasonable and popular solution, as they tend to be overpaid.
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.
Themes
“Article IV. Taxes which, it is intended, should fall indifferently upon every different Species of Revenue.” People must pay capitation taxes (yearly taxes assessed on every person) and taxes on consumable commodities with whatever revenue they happen to have, whether it comes from profit, rent, or wages.
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.
Themes
“Capitation Taxes.” Assessing people’s wealth and income is difficult and invasive, so proportional capitation taxes are usually arbitrary and unfair. Capitation taxes based on rank are less uncertain, but still deeply unfair. Either way, these taxes must be very low, or else people will neither afford nor tolerate them. Still, unfair taxes are more tolerable than unpredictable ones. England historically taxed people based on rank, while France taxes the nobility based on rank and commoners based on wealth. But France imposes its tax more strictly than England. Capitation taxes on workers are equivalent to taxes on wages. But they’re easy to administer, so governments have often chosen them, even though they hurt the poor.
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.
Themes
“Taxes upon consumable Commodities.” Since measuring people’s revenue is hard, many governments have chosen to tax their spending instead by taxing commodities. Some commodities are necessities, including food and whatever a society requires people to own in order to be treated with dignity (like clothing and shoes). All other commodities are luxuries.
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.
Themes
Taxes on necessities raise the price of subsistence, so wages must rise to compensate for the difference. Taxes on luxuries deter people who can’t afford those luxuries from consuming them. Accordingly, such taxes don’t hurt “the sober and industrious poor.” They do hurt “dissolute and disorderly” poor people, but such people don’t contribute much to society, as they have few children, most die, and the survivors are corrupt.
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.
Themes
Taxing necessities makes it harder for the poor to raise more children, which reduces the supply of labor. By increasing wages, taxes on necessities also cause rents to fall and the price of manufactured goods to rise. In this way, they hurt the rich and middle classes too. Britain heavily taxes five necessities: salt, leather, soap, candles, and coal. Despite their harmful effects, these taxes are also an easy source of substantial government revenue. (Instead of repealing them, Britain should focus on repealing the bounty on corn export first.) Other countries heavily tax bread and meat, but meat isn’t truly a necessity.
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.
Themes
To impose commodity taxes, the government can either charge consumers annually for their consumption or tax merchants before they sell their goods. The first system is better for expensive and long-lasting commodities, like coaches, gold and silver plate, and houses. The second system is better for perishable commodities. Proposals to tax everything through the first system are foolish, as such taxes would be unequal, heavy, and inconvenient. For instance, a licensing system for alcohol consumption would punish moderation and encourage drunkenness.
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.
Themes
Most of Britain’s commodity taxes are on luxuries. Some are excise duties (taxes on goods manufactured for domestic consumption) and some are customs duties (taxes on imports and exports). Originally, customs duties were supposed to tax merchants’ profits, so they were imposed on all goods. Later, Britain started assessing special duties on wool, cloth, leather, and wine, while taxing everything else by value.
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.
Themes
Then, Britain adopted the mercantile system. It replaced export duties with bounties and drawbacks, while creating different import duties for different commodities. There are no duties for materials of manufacture, while imports that would compete with domestic manufactured goods are completely prohibited. Most other goods face high import duties. These policies encourage smuggling and fraud, while decreasing Britain’s customs revenue. They encourage merchants to overstate exports and understate imports, which politicians appreciate because it makes Britain’s balance of trade look more favorable than it really is. The import duties are also extremely complicated and difficult to administer.
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.
Themes
It would be better to simplify the system by limiting import duties to a few, widely-consumed goods. For example, most of Britain’s customs revenue comes from European wine and brandy; American rum, tobacco, sugar, and coconuts; and Asian coffee, tea, spices, and porcelain. Import duties on other goods don't raise much revenue for the government—they just protect British manufacturers. If these duties are maintained, they should be designed to raise revenue, without reducing consumption or encouraging smuggling.
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.
Themes
The best way to fight smuggling is by administering the customs tax like an excise tax: customs officers should see and assess imported goods in common warehouses, so that they can ensure that merchants pay the right amount of tax. But this would only be practical if the system is limited to a few common goods—ideally the high-revenue goods listed above. By administering import taxes this way, maximizing revenues instead of protecting monopolies, and abandoning bounties and drawbacks, Britain could create a far simpler customs system without losing any revenue. Indeed, free trade for most goods would benefit merchants, manufacturers, and consumers. But Sir Robert Walpole failed when he tried to impose such a system for wine and tobacco.
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.
Themes
Taxes on imported luxuries mainly affect the wealthy and middle classes. Those on domestically-produced luxuries affect everyone. Since the vast majority of people are poor farmers, tradesmen, and small-time merchants, their expenses and wages account for most of society’s consumption and revenue. (They also earn much of the nation’s total profits and even some of its land rents.) But they should only be taxed for their luxury expenses, and never for their necessities.
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.
Themes
Britain doesn’t tax brewing and distilling for private consumption, so most wealthy families make their own beer (but not their own malt liquor). Malt is used in brewing, but easier to tax than beer and ale. Thus, it’s better to raise the malt tax, eliminate the beer and ale taxes, and lower the taxes on any other products containing malt. This would increase the government’s revenue while keeping spirits expensive (because they harm people’s health and morals) but lowering the price of beer and ale (which are “wholesome and invigorating”).
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.
Themes
This policy wouldn’t hurt malt producers, who will simply raise prices and pass along the tax burden, like any other manufacturer. Indeed, since total beer and ale taxes will fall, the new system will probably increase demand for malt and help maltsters in the long term. It certainly won’t lower rents and profits for barley land. Even if barley rents and profits fell, farmers would start growing something else, since barley land can easily be used to grow other crops. This wouldn’t apply to wine, as vineyard land can’t produce anything else of similar value, or sugar, which is already subject to a monopoly. The new rule would only hurt home brewers, who enjoy unfair advantages under the present system.
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.
Themes
There are many other ways to tax commodities, besides excise and customs duties. For instance, towns and provinces historically charged local tolls for transporting goods, but this obstructs domestic trade, which is essential for economic growth. Strategically-located countries charge transit duties on commodities that pass through their territories.
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%.
Themes
Taxes on luxuries have many advantages. They fall entirely on the people who voluntarily consume luxury products. (However, people who live overseas can still avoid paying taxes, which is a difficult problem to solve.) They are built into the final commodity price, so consumers often don’t even realize they’re paying them. They are also certain and predictable, and they’re convenient for both the government and the consumer because they are paid at the point of sale.
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.
Themes
Luxury taxes’ main disadvantage is their inefficiency: they cost consumers much more than they earn in revenue for the government. First, administering customs duties is very expensive (although excise duties are cheaper). Second, luxury taxes reduce consumption and suppress industry by raising prices. Third, they encourage smuggling, which is an unproductive waste of capital and labor. Finally, luxury taxes force merchants to put up with visits from tax collectors, which are irritating and inconvenient—especially for excise duties.
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.
Themes
Britain’s tax system is still less burdensome than other countries’. Spain and Naples tax goods every time they are sold, which discourages serious domestic commerce. Britain’s uniform tax system makes domestic trade almost completely free, while France’s complex patchwork of province- and city-level tax laws is inefficient and expensive to administer. The systems in Milan and Parma are even more convoluted.
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.
Themes
It’s always cheaper and more reliable for the government to directly employ tax officers, rather than hiring tax farmers (private third-party tax collectors). These tax farmers lobby for harsher tax laws, establish monopolies over certain taxes, encourage smuggling, and pass on the cost of their exorbitant profits to consumers. For instance, in France, the five taxes administered by private collectors are full of waste, while the three managed by government collectors pass on nearly all their revenue to the crown.
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.)
Themes
France should replace its unfair land tax (taille) and capitation tax with more revenue taxes (vingtièmes), particularly on the rich. It should unify its customs and excise duties to permit free domestic trade, and it should give all tax collection authority to government inspectors. Private interests will fight all three reforms. Britain earns 10 million pounds annually in tax revenue, but even with triple the population and much better land, France only earns 15 million. Holland’s high taxes have destroyed its manufacturing sector, but these may have been necessary to cover its high expenses for war and land reclamation. Besides, there are enough rich families in Holland to keep its economy going.
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.
Themes
