One of the oldest problems connected with taxation is: Who pays the tax? It would seem that the answer is clear-cut, since the government knows on whom it levies a tax. The problem, however, is not who pays the tax immediately, but who pays it in the long run, i.e., whether or not the tax can be “shifted” from the immediate taxpayer to somebody else. Shifting occurs if the immediate taxpayer is able to raise his selling price to cover the tax, thus “shifting” the tax to the buyer, or if he is able to lower the buying price of something he buys, thus “shifting” the tax to some other seller.

In addition to this problem of the incidence of taxation, there is the problem of analyzing other economic effects of various types and amounts of taxes.

The first law of incidence can be laid down immediately, and it is a rather radical one: No tax can be shifted forward. In other words, no tax can be shifted from seller to buyer and on to the ultimate consumer. Below, we shall see how this applies specifically to excise and sales taxes, which are commonly thought to be shifted forward. It is generally considered that any tax on production or sales increases the cost of production and therefore is passed on as an increase in price to the consumer. Prices, however, are never determined by costs of production, but rather the reverse is true. The price of a good is determined by its total stock in existence and the demand schedule for it on the market. But the demand schedule is not affected at all by the tax. The selling price is set by any firm at the maximum net revenue point, and any higher price, given the demand schedule, will simply decrease net revenue. A tax, therefore, cannot be passed on to the consumer.

It is true that a tax can be shifted forward, in a sense, if the tax causes the supply of the good to decrease, and therefore the price to rise on the market. This can hardly be called shifting per se, however, for shifting implies that the tax is passed on with little or no trouble to the producer. If some producers must go out of business in order for the tax to be “shifted,” it is hardly shifting in the proper sense but should be placed in the category of other effects of taxation.

A general sales tax is the classic example of a tax on producers that is believed to be shifted forward. The government, let us say, imposes a 20-percent tax on all sales at retail. We shall assume that the tax can be equally well enforced in all branches of sales.10 To most people, it seems obvious that the business will simply add 20 percent to their selling prices and merely serve as unpaid collection agencies for the government. The problem is hardly that simple, however. In fact, as we have seen, there is no reason whatever to believe that prices can be raised at all. Prices are already at the point of maximum net revenue, the stock has not been decreased, and demand schedules have not changed. Therefore, prices cannot be increased. Furthermore, if we look at the general array of prices, these are determined by the supply of and the demand for money. For the array of prices to rise, there must be an increase in the supply of money, a decrease in the schedule of the demand for money, or both. Yet neither of these alternatives has occurred. The demand for money to hold has not decreased, the supply of goods available for money has not declined, and the supply of money has remained constant. There is no possible way that a general price increase can be obtained.11

It should be quite evident that if businesses were able to pass tax increases along to the consumer in the form of higher prices, they would have raised these prices already without waiting for the spur of a tax increase. Businesses do not deliberately peg along at the lowest selling prices they can find. If the state of demand had permitted higher prices, firms would have taken advantage of this fact long before. It might be objected that a sales tax increase is general and therefore that all the firms together can shift the tax. Each firm, however, follows the state of the demand curve for its own product, and none of these demand curves has changed. A tax increase does nothing to make higher prices more profitable.

The myth that a sales tax can be shifted forward is comparable to the myth that a general union-imposed wage increase can be shifted forward to higher prices, thereby “causing inflation.” There is no way that the general array of prices can rise, and the only result of such a wage increase will be mass unemployment.12

Many people are misled by the fact that the price the consumer pays must necessarily include the tax. When someone goes to a movie and sees prominently posted the information that the $1.00 admission covers a “price” of 85 cents and a tax of 15 cents, he tends to conclude that the tax has simply been added on to the “price.” But $1.00 is the price, not 85 cents, the latter sum being the income accruing to the firm after taxes. This income might well have been reduced to allow for payment of taxes.

In fact, this is precisely the effect of a general sales tax. Its immediate impact lowers the gross revenue of firms by the amount of the tax. In the long run, of course, firms cannot pay the tax, for their loss in gross revenue is imputed back to interest income by capitalists and to wages and rents earned by original factors—labor and ground land. A decrease in the gross revenue of retail firms is reflected back to a decreased demand for the products of all the higher-order firms. All the firms, however, earn, in the long run, a pure uniform interest return.

Here a difference arises between a general sales tax and, say, a corporate income tax. There has been no change in time-preference schedules or other components of the interest rate. While an income tax compels a lower percent interest return, a sales tax can and will be shifted completely from investment and back to the original factors. The result of a general sales tax is a general reduction in the net revenue accruing to original factors: to all wages and ground rents. The sales tax has been shifted backwards to original factor returns. No longer does every original factor of production earn its discounted marginal value product. Now, original factors earn less than their DMVPs, the reduction consisting of the sales tax paid to the government.

It is necessary now to integrate this analysis of the incidence of a general sales tax with our previous general analysis of the benefits and burdens of taxation. This is accomplished by remembering that the proceeds of taxation are, in turn, spent by the government.13 Whether the government spends the money for resources for its own activities or simply transfers the money to people it subsidizes, the result is to shift consumption and investment demand from private hands to the government or to government-supported individuals, by the amount of the tax revenue. In this case, the tax has been ultimately levied on the incomes of original factors, and the money transferred from their hands to the government. The income of the government and/or those it subsidizes has been increased at the expense of those taxed, and therefore consumption and investment demands on the market have been shifted from the latter to the former by the amount of the tax. As a consequence, the value of the money unit will remain unchanged (barring a difference in demands for money between the taxpayers and the tax consumers), but the array of prices will shift in accordance with the shift in demands. Thus, if the market has been spending heavily on clothing, and the government uses the revenue mostly for the purchase of arms, there will be a fall in the price of clothes, a rise in the price of arms, and a tendency for nonspecific factors to shift out of clothing and into the production of armaments.

As a result, there will not be, as might be assumed, a proportional 20-percent fall in the incomes of all original factors as a result of a 20-percent general sales tax. Specific factors in industries that have lost business as a result of the shift from private to governmental demand will lose proportionately more in income. Specific factors in industries gaining in demand will lose proportionately less, and some may gain so much as to gain absolutely as a result of the change. Nonspecific factors will not be affected as much proportionately, but they too will lose and gain according to the difference that the concrete shift in demand makes in their marginal value productivity.

The knowledge that taxes can never be shifted forward is a consequence of adhering to the “Austrian” analysis of value, i.e., that prices are determined by ultimate demands for stock, and not in any sense by the “cost of production.” Unhappily, all previous discussions of the incidence of taxation have been marred by hangovers of classical “cost-of-production” theory and the failure to adopt a consistent “Austrian” approach. The Austrian economists themselves never really applied their doctrines to the theory of tax incidence, so that this discussion breaks new ground.

The shifting-forward doctrine has actually been carried to its logical, and absurd, conclusion that producers shift taxes to consumers, and consumers, in turn, can shift them to their employers, and so on ad infinitum, with no one really paying any tax at all.14

It should be carefully noted that the general sales tax is a conspicuous example of failure to tax consumption. It is commonly supposed that a sales tax penalizes consumption rather than income or capital. But we find that the sales tax reduces, not just consumption, but the incomes of original factors. The general sales tax is an income tax, albeit a rather haphazard one, since there is no way that its impact on income classes can be made uniform. Many “right-wing” economists have advocated general sales taxation, as opposed to income taxation, on the ground that the former taxes consumption but not savings-investment; many “left-wing” economists have opposed sales taxation for the same reason. Both are mistaken; the sales tax is an income tax, though of more haphazard and uncertain incidence. The major effect of the general sales tax will be that of the income tax: to reduce the consumption and the savings-investment of the taxpayers.15 In fact, since, as we shall see, the income tax by its nature falls more heavily on savings-investment than on consumption, we reach the paradoxical and important conclusion that a tax on consumption will also fall more heavily on savings-investment, in its ultimate incidence.

• 10Usually, of course, it cannot, and the result will be equivalent to a specific excise tax on some branches of sales, but not on others.
• 11Whereas a partial excise tax will eventually cause a drop in supply and therefore a rise in the price of the product, there is no way by which resources can escape a general tax except into idleness. Since, as we shall see, a sales tax is a tax on incomes, the rise in the opportunity cost of leisure may push some workers into idleness, and thereby lower the quantity of goods produced. To this tenuous extent, prices will rise. See the pioneering article by Harry Gunnison Brown, “The Incidence of a General Sales Tax,” reprinted in R.A. Musgrave and C.S. Shoup, eds., Readings in the Economics of Taxation (Homewood, Ill.: Richard D. Irwin, 1959), pp. 330–39. This was the first modern attack on the fallacy that sales taxes are shifted forward, but Brown unfortunately weakened the implications of this thesis toward the end of his article.
• 12Of course, if the money supply is increased and credit expanded, prices can be raised so that money wages are no longer above their discounted marginal value products.
• 13If the government does not spend all of its revenue, then deflation is added to the impact of taxation. See below.
• 14For example, see E.R.A. Seligman, The Shifting and Incidence of Taxation (2nd ed.; New York: Macmillan & Co., 1899), pp. 122–33.
• 15Mr. Frank Chodorov, in his The Income Tax—Root of All Evil (New York: Devin-Adair, 1954), fails to indicate what other type of tax would be “better” from a free-market point of view than the income tax. It will be clear from our discussion that there are few taxes indeed that will not be as bad as the income tax from the viewpoint of an advocate of the free market. Certainly, sales or excise taxation will not fill the bill.
      Chodorov, furthermore, is surely wrong when he terms income and inheritance taxes unique denials of the right of individual property. Any tax whatever infringes on property rights, and there is nothing in an “indirect tax” which makes that infringement any less clear. It is true that an income tax forces the subject to keep records and disclose his personal dealings, thus imposing a further loss in his utility. The sales tax, however, also forces record-keeping; the difference again is one of degree rather than of kind, for here the extent of directness covers only retail storekeepers instead of the bulk of the population.

The partial excise tax is a sales tax levied on some, rather than all, commodities. The chief distinction between this and the general sales tax is that the latter does not, in itself, distort productive allocations on the market, since a tax is levied proportionately on the sale of all final products. A partial excise, on the other hand, penalizes certain lines of production. The general sales tax, of course, distorts market allocations insofar as government expenditures from the proceeds differ in structure from private demands in the absence of the tax. The excise tax has this effect, too, and, in addition, penalizes the particular industry taxed. The tax cannot be shifted forward, but tends to be shifted backward to the factors working in the industry. Now, however, the tax exerts pressure on nonspecific factors and entrepreneurs to leave the taxed industry and enter other, non-taxed industries. During the transition period, the tax may well be added to cost. As the price, however, cannot be directly increased, the marginal firms in this industry will be driven out of business and will seek better opportunities elsewhere. The exodus of nonspecific factors, and perhaps firms, from the taxed industry reduces the stock of the good that will be produced. This reduction in stock, or supply, will raise the market price of the good, given the consumers’ demand schedule. Thus, there is a sort of “indirect shifting” in the sense that the price of the good to consumers will ultimately increase. However, as we have stated, it is not appropriate to call this “shifting,” a term better reserved for an effortless, direct passing on of a tax in the price.

Everyone in the market suffers as a result of an excise tax. Nonspecific factors must shift to fields of lower income; since the discounted marginal value product is lower there, specific factors are hit particularly hard, and consumers suffer as the allocations of factors and the price structure are distorted in comparison with what would have satisfied their desires. The supply of factors in the taxed industries becomes excessively low, and the selling price in these industries too high; while the supply of factors in other industries becomes excessively large, and their product prices too low.

In addition to those specific effects, the excise tax also has the same general effect as all other taxes, viz., that the pattern of market demands is distorted from private to government or government-subsidized wants by the amount of the tax intake.

Far too much has been written on the elasticity of demand in relation to the effect of taxation. We know that the demand schedule for one firm is always elastic above the free-market price. And the cost of production is not something fixed, but is in itself determined by the selling price. Most important, since the demand curve for a good is always falling, any decrease in the stock will raise the market price, and any increase in the stock will lower the price, regardless of the elasticity of demand for the product. Elasticity of demand is a topic that warrants only a relatively minor role in economic theory.16

In sum, an excise tax (a) injures consumers in the same way that all taxes do, by shifting resources and demands from private consumers to the State; and (b) injures consumers and producers in its own particular way by distorting market allocations, prices, and factor revenues; but (c) cannot be considered a tax on consumption in the sense that the tax is shifted to consumers. The excise tax is also a tax on incomes, except that in this case the effect is not general because the impact falls most heavily on the factors specific to the taxed industry.

Any partial tax on production will have effects similar to an excise tax. A license tax imposed on an industry, for example, granting a monopolistic privilege to firms with a large amount of capital, will restrict the supply of the product and raise the price. Factors and pricing will be misallocated as in an excise tax. In contrast to the latter, however, the indirect grant of monopolistic privilege will benefit the specific, quasi-monopolized factors that are able to remain in the industry.

• 16Perhaps the reason for the undeserved popularity of the elasticity concept is that economists need to employ it in their vain search for quantitative laws and measurements in economics.

In the dynamic real economy, money income consists of wages, ground rents, interest, and profits, counterbalanced by losses. (Ground rents are also capitalized on the market, so that income from rents is resolvable into interest and profit, minus losses.) The income tax is designed to tax all such net income. We have seen that sales and excise taxes are really taxes on some original-factor incomes. This has been generally ignored, and perhaps one reason is that people are accustomed to thinking of income taxation as being uniformly levied on all incomes of the same amount. Later, we shall see that the uniformity of such a levy has been widely upheld as an important “canon of justice” for taxation. Actually, no such uniformity does or need exist. Excise and sales taxes, as we have seen, are not uniformly levied, but are imposed on some income receivers and not others of the same income class. It must be recognized that the official income tax, the tax that is generally known as the “income tax,” is by no means the only form in which income is, or can be, taxed by the government.17

An income tax cannot be shifted to anyone else. The taxpayer himself bears the burden. He earns profits from entrepreneurial activity, interest from time preference, and other income from marginal productivity, and none can be increased to cover the tax. Income taxation reduces every taxpayer’s money income and real income, and hence his standard of living. His income from working is more expensive, and leisure cheaper, so that he will tend to work less. Everyone’s standard of living in the form of exchangeable goods will decline. In rebuttal, much has been made of the fact that every man’s marginal utility of money rises as his money assets fall and, therefore, that there may be a rise in the marginal utility of the reduced income obtainable from his current expenditure of labor. It is true, in other words, that the same labor now earns every man less money, but this very reduction in money income may also raise the marginal utility of a unit of money to the extent that the marginal utility of his total income will be raised, and he will be induced to work harder as a result of the income tax. This may very well be true in some cases, and there is nothing mysterious or contrary to economic analysis in such an event. However, it is hardly a blessing for the man or for society. For, if more work is expended, leisure is lost, and people’s standards of living are lower because of this coerced loss.

In the free market, in short, individuals are always balancing their money income (or real income in exchangeable goods) against their real income in the form of leisure activities. Both are basic components of the standard of living. The greater their exchangeable-goods income, in fact, the higher will be their marginal utility of a unit of leisure time (nonexchangeable goods), and the more proportionately will they “take” their income in the form of leisure. It is not surprising, therefore, that a coerced lower income may force individuals to work harder. Whichever the effect, the tax lowers the standard of living of the taxpayers, either depriving them of leisure or of exchangeable goods.

In addition to penalizing work relative to leisure, an income tax also penalizes work for money as against work for a return in kind. Obviously, a relative advantage is conferred on work done for a nonmonetary reward. Working women are penalized as compared with housewives; people will tend to work for their families rather than enter into the labor market, etc. “Do-it-yourself” activities are stimulated. In short, the income tax tends to bring about a reduction in specialization and a breakdown of the market, and hence a retrogression in living standards.18 Make the income tax high enough, and the market will disintegrate altogether, and primitive economic conditions will prevail.

The income tax confiscates a certain portion of a person’s income, leaving him free to allocate the remainder between consumption and investment. It might be thought that, since we may assume time-preference schedules as given, the proportion of consumption to savings-investment—and the pure interest rate—will remain unaffected by the income tax. But this is not so. For the taxpayer’s real income and the value of his monetary assets have been lowered. The lower the level of a man’s real monetary assets, the higher will his time-preference rate be (given his time-preference schedule) and the higher the proportion of his consumption to investment spending. The taxpayer’s position may be seen in the diagram in Figure 4.

FIGURE 4. AN INDIVIDUAL TIME-PREFERENCE SCHEDULE

Figure 4 is a portrayal of an individual taxpayer’s time-preference schedule, related to his monetary assets. Let us say that the taxpayer’s initial position is a stock of 0M; tt is his time-preference curve. His effective time-preference rate, determining the ratio of his consumption to his savings-investment is t1. Now the government levies an income tax, reducing his initial monetary assets at the start of his spending period to 0M1. His effective time-preference rate is now higher, at t2. We have seen that an individual’s real as well as nominal money assets must decline in order for this result to take place; if there is deflation, the value of the monetary unit will increase roughly in proportion, and, in the long run, time-preference ratios, ceteris paribus, will not be changed. In the case of income taxation, however, there will be no change in the value of the monetary unit, since the government will spend the proceeds of taxation. As a result, the taxpayer’s real as well as nominal money assets decline, and decline to the same extent.

It might be objected that the government officials or those subsidized receive additional money, and the fall in their time-preference ratios may well offset, or balance, the rise in the rate from the taxpayers’ side. It could not be concluded, then, that the social rate of time-preference will rise, and savings-investment particularly decrease. Government expenditures, however, constitute diversion of resources from private to government purposes. Since the government, by definition, desires this diversion, this is a consumption expenditure by the government.19 The reduction in income (and therefore in consumption and savings-investment) imposed on the taxpayers will therefore be counterbalanced by government consumption-expenditure. As for the transfer expenditures made by the government (including the salaries of bureaucrats and subsidies to privileged groups), it is true that some of this will be saved and invested. These investments, however, will not represent the voluntary desires of consumers, but rather investments in fields of production not desired by the producing consumers. They represent the desires, not of the producing consumers on the free market, but of exploiting consumers fed by the unilateral coercion of the State. Once let the tax be eliminated, and the producers are free to earn and consume again. The new investments called forth by the demands of the specially privileged will turn out to be malinvestments. At any rate, the amount consumed by the government insures that the effect of income taxation will be to raise time-preference ratios and to reduce saving and investment.

Some economists maintain that income taxation reduces saving and investment in the society in a third way. They assert that income taxation, by its very nature, imposes a “double” tax on savings-investment as against consumption.20 The reasoning runs as follows: Saving and consumption are not really symmetrical. All saving is directed toward enjoying more consumption in the future. Otherwise, there would be no point at all in saving. Saving is abstaining from possible present consumption in return for the expectation of increased consumption at some time in the future. No one wants capital goods for their own sake.21 They are only the embodiment of an increased consumption in the future. Savings-investment is Crusoe’s building a stick to obtain more apples at a future date; it fructifies in increased consumption later. Hence, the imposition of an income tax excessively penalizes savings-investment as against consumption.22

This line of reasoning is correct in its explanation of the investment-consumption process. It suffers, however, from one grave defect: it is irrelevant to problems of taxation. It is true that saving is a fructifying agent. But the point is that everyone knows this; that is precisely why people save. Yet, even though they know that saving is a fructifying agent, they do not save all their income. Why? Because of their time preference for present consumption. Every individual, given his current income and value scales, allocates that income in the most desired proportion among consumption, investment, and addition to his cash balance. Any other allocation would satisfy his desires to a lesser extent and lower his position on his value scale. There is therefore no reason here to say that an income tax especially penalizes savings-investment; it penalizes the individual’s entire standard of living, encompassing present consumption, future consumption, and his cash balance. It does not per se penalize saving any more than it does the other avenues of income allocation.

There is another way, however, in which an income tax does, in fact, levy a particular burden on saving. For the interest return on savings-investment, like all other earnings, is subject to the income tax. The net interest rate received, therefore, is lower than the free-market rate. The return is not consonant with free-market time preferences; instead, the imposed lower return induces people to bring their savings-investment into line with the reduced return; in short, the marginal savings and investments, now not profitable at the lower rate, will not be made.

The above Fisher-Mill argument is an example of a curious tendency among economists generally devoted to the free market to be unwilling to consider its ratio of consumption to investment allocations as optimal. The economic case for the free market is that market allocations tend at all points to be optimal with respect to consumer desires. The economists who favor the free market recognize this in most areas of the economy but for some reason show a predilection for and special tenderness toward savings-investment, as against consumption. They tend to feel that a tax on saving is far more of an invasion of the free market than a tax on consumption. It is true that saving embodies future consumption. But people voluntarily choose between present and future consumption in accordance with their time preferences, and this voluntary choice is their optimal choice. Any tax levied particularly on their consumption, therefore, is just as much a distortion and invasion of the free market as a tax on their savings. There is nothing, after all, especially sacred about savings; they are simply the road to future consumption. But they are no more important than present consumption, the allocation between the two being determined by the time preferences of all individuals. The economist who shows more concern for free-market savings than he does for free-market consumption is implicitly advocating statist interference and a coerced distortion of resource allocation in favor of greater investment and lower consumption. The free-market advocate should oppose with equal fervor coerced distortion of the ratio of consumption to investment in either direction.23

As a matter of fact, we have seen that income taxation, by other routes, tends to distort the allocation of resources into more consumption and less savings-investment, and we have seen above that attempts to tax consumption in the form of sales or production taxation must fail and end as levies on incomes instead.

• 17Even the official tax is hardly uniform, being interlarded with extra burdens and exemptions. See below for further discussion of uniformity of taxation.
• 18See C. Lowell Harriss, “Public Finance” in Bernard F. Haley, ed., A Survey of Contemporary Economics (Homewood, Ill.: Richard D. Irwin, 1952), II, 264. For a practical example, see P.T. Bauer, “The Economic Development of Nigeria,” Journal of Political Economy, October, 1955, pp. 400 ff.
• 19These expenditures are commanded by the government, and not by the free action of individuals. They therefore may satisfy the utility (or are expected to satisfy the utility) only of the government officials, and we cannot be sure that anyone else’s is satisfied.
      The Keynesians, on the contrary, classify all government resource-using expenditure as “investment,” on the ground that these, like investment expenditures, are “independent,” and not passively tied to income by means of a psychological “function.”
• 20Thus, see Irving and Herbert W. Fisher, Constructive Income Taxation (New York: Harper & Bros., 1942). “Double” is used in the sense of two instances, not arithmetically twice.
• 21Although there is much merit in Professor Due’s critique of this general position, he is incorrect in believing that people may own capital for its own sake. If people, because of the uncertainty of the future, wish to hold wealth for its service in relieving risk, they will hold wealth in its most marketable form—cash balances. Capital is far less marketable and is desired only for its fructification in consumers’ goods and earnings from the sale of these goods. John F. Due, Government Finance (Home-wood, Ill.: Richard D. Irwin, 1954), pp. 123–25, 368 ff.
• 22These economists generally go on to advocate taxation of consumption alone as the only “real” income. For further discussion of such a consumption tax, see below.
• 23Thus, one of the standard conservative arguments against progressive income taxation (see below) is that savings would be taxed in greater proportion than consumption; many of these writers leave the reader with the inference that if (present) consumption were taxed more heavily, everything would be all right. Yet what is so worthy about future, as against present, consumption, and what principle do these economists sadopt that permits them to alter by force the voluntary time-preference ratios between present and future?

(1) Taxes on Wages

A tax on wages is an income tax that cannot be shifted away from the wage earner. There is no one to shift it to, especially not the employer, who always tends to earn a uniform interest rate. In fact, there are indirect taxes on wages that are shifted to the wage earner in the form of lower wage incomes. An example is that part of social security, or of unemployment compensation premiums, levied on the employer. Most employees believe that they completely escape this part of the tax, which the employer pays. They are wholly mistaken. The employer, as we have seen, cannot shift the tax forward to the consumer. In fact, since the tax is levied in proportion to wages paid, the tax is shifted backward wholly on the wage earners themselves. The employer’s part is simply a collected tax levied at the expense of a reduction of the net wages of the employees.

(2) Corporate Income Taxation

Taxation of corporate net income imposes a “double” tax on the owners of corporations: once on the official “corporate” income and once on the remaining distributed net income of the owners themselves. The extra tax cannot be shifted forward onto the consumer. Since it is levied on net income itself, it can hardly be shifted backward. It has the effect of penalizing corporate income as opposed to income from other market forms (single ownership, partnerships, etc.), thereby penalizing efficient forms of enterprise and encouraging the inefficient. Resources shift from the former to the latter until the expected rate of net return is equalized throughout the economy—at a lower level than originally. Since interest return is forcibly lower than before, the tax penalizes savings and investment as well as an efficient market form.24

The penalty, or “double-taxation,” feature of corporate income taxes could be eliminated only by abolishing the tax and treating any net incomes accruing to a corporation as pro rata income to its stockholder-owners. In other words, a corporation would be treated as a partnership, and not according to the absurd fiction that it is some sort of separate real entity functioning apart from the actions of its actual owners. Income accruing to the corporation obviously accrues pro rata to the owners. Some writers have objected that the stockholders do not really receive the income on which they would be taxed. Thus, suppose that the Star Corporation earns a net income of $100,000 in a certain period, and that it has three stockholders—Jones, with 40 percent of the stock; Smith, holding 35 percent of the stock; and Robinson, owning 25 percent. The majority stockholders, or their management representatives, decide to retain $60,000 as “undistributed” earnings “in the firm,” while paying only $40,000 as dividends. Under present law, Jones’ net income from the Star Corporation is considered as $16,000, Smith’s as $14,000, and Robinson’s as $10,000; the “corporation’s” is listed at $100,000. Each of these entities is then taxed on these amounts. Yet, since there is no real corporate entity separate from its owners, the incomes would be more properly recorded as follows: Jones, $40,000; Smith, $35,000; Robinson, $25,000. The fact that these stockholders do not actually receive the money is no objection; for what happens is the equivalent of someone’s earning money yet keeping it on account without bothering to draw it out and use it. Interest that piles up in someone’s savings bank account is considered as income and taxed accordingly, and there is no reason why “undistributed” earnings should not be considered individual income as well.

The fact that total corporate income is first taxed and then “distributed” as dividend income to be taxed again, encourages a further distortion of market investment and organization. For this practice encourages stockholders to leave a greater proportion of their earnings undistributed than they would have done in a free market. Earnings are “frozen in” and either held or invested in an uneconomic fashion in relation to the satisfaction of consumer wants. To the reply that this at least fosters investment, there are two rejoinders: (1) that a distortion in favor of investment is as much a distortion of optimum market allocations as anything else; and (2) that not “investment” is encouraged, but rather frozen investment by owners back into their original firms at the expense of mobile investment. This distorts and renders inefficient the pattern and allocation of investment funds and tends to freeze them in the original firms, discouraging the diffusion of funds to different concerns. Dividends, after all, are not necessarily consumed: they may be reinvested in other firms and other investment opportunities. The corporate income tax greatly hampers the adjustment of the economy to dynamic changes in conditions.

(3) “Excess” Profit Taxation

This tax is generally levied on that part of business net income, dubbed “excess,” which is greater than a base income in a previous period of time. A penalty tax on “excess” business income directly penalizes efficient adjustment of the economy. The profit drive by entrepreneurs is the motive power that adjusts, estimates, and coordinates the economic system so as to maximize producer income in the service of maximizing consumer satisfactions. It is the process by which malinvestments are kept to a minimum, and good forecasts encouraged, so as to arrange advance production to be in close harmony with consumer desires at the date when the final product appears on the market. Attacking profits “doubly” disrupts and hampers the whole market-adjustment process. Such a tax penalizes efficient entrepreneurship. Furthermore, it helps to freeze market patterns and entrepreneurial positions as they were in some previous time period, thus distorting the economy more and more as time passes. No economic justification can be found for attempting to freeze market patterns in the mould of some previous period. The greater the changes in economic data that have occurred, the more important it is not to tax “excess” profits, or any form of “excess” revenue for that matter; otherwise, adaptation to the new conditions will be blocked just when rapid adjustment is particularly required. It is difficult to find a tax more indefensible from more points of view than this one.

(4) The Capital Gains Problem

Much discussion has raged over the question: Are capital gains income? It seems evident that they are; indeed, capital gain is one of the leading forms of income. In fact, capital gain is the same as profit. Those who desire uniformity of income-pattern taxation would therefore have to include capital gains if all forms of monetary profit are to be brought into the category of taxable income.25 Using as an example the Star Corporation described above, let us consider Time1 to be the period just after the corporation has earned $100,000 net income and just before it decides where to allocate this income. In short, it is at a decision point in time. It has earned a profit of $100,000.26 At Time1, its capital value has therefore increased by $100,000. The stockholders have, in the aggregate, earned a capital gain of $100,000, but this is the same as their aggregate profit. Now the Star Corporation keeps $60,000 and distributes $40,000 in dividends, and for the sake of simplicity we shall assume that the stockholders consume this amount. What is the situation at Time2, after this allocation has taken place? In comparison with the situation prevailing originally, say at Time0, we find that the capital value of the Star Corporation has increased by $60,000. This is unquestionably part of the income of the stockholders; yet, if uniform income taxation is desired, there is no need to levy a tax on it, for it was already included in the $100,000 income of the stockholders subject to tax.

The stock market always tends toward an accurate reflection of the capital value of a firm; one might think, therefore, that the quoted value of the firm’s shares would increase, in the aggregate, by $60,000. In the dynamic world, however, the stock market reflects anticipations of future profit, and therefore its values will diverge from the relatively ex post accounting of the firm’s balance sheet. Furthermore, entrepreneurship, in addition to profits and losses, will be reflected in the valuations of the stock market as well as in business enterprises directly. A firm may be making slim profits now, but a farseeing entrepreneur will purchase stock from more shortsighted ones. A rise in price will net him a capital gain, and this is a reflection of his entrepreneurial wisdom in directing capital. Since it would be impossible administratively to identify the profits of the firm, it would be better from the point of view of uniform income taxation not to tax the business income of corporate stockholders at all, but to tax a stockholder’s capital gains instead. Whatever gains the owners reap will be reflected in capital gains on their stock anyway, so that taxation of the business income itself becomes unnecessary. On the other hand, taxation of business income while exempting capital gains would exclude from “income” the entrepreneurial gains reaped on the stock market. In the case of partnerships and single enterprises that are not owned in shares of stock, the business income of the owners would, of course, be taxed directly. Taxation of both business income (i.e., profits accruing to stockholders) and capital gains on stock would impose a double tax on efficient entrepreneurs. A genuinely uniform income tax, then, would not tax a stockholder’s pro rata business income at all, but rather the capital gain from his shares of stock.

If business profits (or capital gains) are income subject to tax, then, of course, business losses or capital losses are a negative income, deductible from other income earned by any particular individual.

What of the problem of land and housing? Here, the same situation obtains. Landlords earn income annually, and this may be included in their net income as business profits. However, real estate, while not given to stock ownership, also has a flourishing capital market. Land is capitalized, and capital values increase or dwindle on the capital market. It is clear that, once again, the government has an alternative if it desires to impose uniform personal income taxes: either it can impose the tax on net profits from real estate, or it can forgo this and impose a tax on increases in the capital values of real estate. If it does the former, it will omit the entrepreneurial gains and losses made on the capital market, the regulator and anticipator of investment and demand; if it does both, it imposes a double tax on this form of business. The best solution (once again within the context of a uniform income tax) is to impose a tax on the capital gain minus the capital loss on the land values.

It must be emphasized that a capital gains tax is truly an income tax only when it is levied on accrued, rather than on realized, capital gains or losses. In other words, if a man’s capital assets have increased during a certain period, from 300 ounces of gold to 400 ounces, his income is 100 ounces, whether or not he has sold the asset to “take” the profit. In any period, his earnings consist not simply in what he may use for spending. The situation is analogous to that of a corporation’s undistributed profits, which as we have seen, must be included in each stockholder’s accumulation of income. Taxing realized gains and losses introduces great distortions into the economy; it then becomes highly advantageous to investors never to sell their stock, but to hand it down to future generations. Any sale would require the old owner to pay the capital gains levy accumulated for an entire period. The effect is to “freeze” an investment in the hands of one person, and particularly of one family, for generations. The result is rigidity in the economy and failure of the hampered market to meet flexibly the continual changes in data that always take place. As time goes on, the distortive effects of the economic rigidity grow worse and worse.

Another serious hampering of the capital market results from the fact that, once the capital gain is “taken” or realized, the income tax on this particular gain is actually far higher and not uniform. For the capital gains accrue over a long stretch of time, and not simply at the point of sale. But the income tax is based only on each year’s realized income. In other words, a man who realizes his gain in a certain year must pay a far bigger tax in that year than would be “justified” by a tax on his actually acquired income during the year. Suppose, for example, that a man buys a capital asset at 50 and its market value increases by 10 each year, until he finally sells it for 90 in four years’ time. For three years, his income of 10 goes untaxed, while in the fourth year he is taxed on an income of 40 when his income was only 10. The final tax, therefore, largely becomes one on accumulated capital rather than on income.27 The incentive for keeping investment rigid, therefore, becomes even greater.28

There are, of course, grave difficulties in any such tax on accrued capital gains, but, as we shall see, there are many insuperable obstacles to any attempt to impose uniform income taxes. Estimates of market value would pose the greatest problem. Appraisals are always simply conjectures, and there would be no way of knowing that the assessed value was the correct one.

Another insuperable difficulty arises from changes in the purchasing power of the monetary unit. If the purchasing power has fallen in half, then a change in capital value of an asset from 50 to 100 does not represent a real capital gain; it simply reflects the maintenance of real capital as nominal values double. Clearly, a constant nominal value of capital when other prices and values double would reflect a high capital loss—a halving of real capital value. To reflect gains or losses in income, then, a person’s capital gain or loss would have to be corrected for changes in the purchasing power of money. Thus, a fall in purchasing power tends to result in the overstatement of business income and hence leads to a consumption of capital. But if a man’s capital gains or losses must be corrected for changes in the purchasing power of money in order to state his true income for a certain period, what standards can be used for such a correction? For changes in purchasing power cannot be measured. Any “index” used would be purely arbitrary. Whichever method is adopted, therefore, uniformity in income taxation cannot be achieved, because an accurate measurement of income cannot be attained.29

Thus, to the controversial question, “Are capital gains income?” the answer is emphatically yes, provided that (1) a correction is made for changes in the purchasing power of the monetary unit, and (2) the accrued rather than the realized capital gain is considered. In fact, whenever businesses are owned by stockholders (and bondholders), the gains on these stocks and bonds will provide a fuller guide to income earned than the actual net income of the firm. If it is desired to tax incomes uniformly, then taxes would have to be levied on the former only; to tax both would be to level a “double” tax on the same income.

Professor Groves, while agreeing that capital gains are income, lists several reasons for giving capital gains preferential treatment.30 Almost all of them apply, however, to taxation on realized, rather than on accrued, capital gains. The only relevant case is the familiar one that “capital gains and losses are not regularly recurrent, as are most other incomes.” But no income is “regularly recurrent.” Profits and losses, of course, are volatile, being based on speculative entrepreneurship and adjustments to changing conditions. Yet no one contends that profits are not income. All other income is flexible as well. No one has a guaranteed income on the free market. Everyone’s resources are subject to change as conditions and the data of the market change. That the division between income and capital gains is illusory is demonstrated by the confusion over the classification of authors’ incomes. Is the income in one year resulting from five years’ writing of a book “income” or an increase in the “capital worth” of the author? It should be evident that this entire distinction is valueless.31

Capital gains are profits. And the real value of aggregate capital gains in society will equal total aggregate profits. A profit increases the capital worth of the owner, whereas a loss decreases it. Moreover, there are no other sources from which real capital gains can come. What of the savings of individuals? Individual savings, to the extent that they do not add to cash balances, go into investments. These purchases of capital lead to capital gains for stockholders. Aggregate savings lead to aggregate capital gains. But it is also true that profits can exist in the aggregate only when there is aggregate net saving in the economy. Thus, aggregate pure profits, aggregate capital gains, and aggregate net savings all go hand in hand in the economy. Net dissavings lead to aggregate pure losses and aggregate capital losses.

To sum up, if it is desired to tax uniformly (this goal will be analyzed critically below), the correct procedure would be to consider capital gains as equivalent to income when corrected for changes in the purchasing power of the monetary unit, and to consider capital losses as negative income. Some critics charge that it would be discriminatory to correct capital for changes in prices without doing the same for income, but this objection misses the point. If the desire is to tax income rather than accumulated capital, it is necessary to correct for changes in the purchasing power of money. For example, capital rather than pure income is being taxed during an inflation.

(5) Is a Tax on Consumption Possible?

We have seen that attempts to tax consumption via sales and excise taxes are vain and that they inexorably result in a tax on incomes. Irving Fisher has suggested an ingenious plan for a consumption tax—a direct tax on the individual akin to the income tax, requiring annual returns, etc. The base for the individual’s tax, however, would be his income, minus net additions to his capital or cash balance, plus net subtractions from that capital for the period—i.e., his consumption spending. The individual’s consumption spending would then be taxed in the same way as his income is now.32 We have seen the fallacy in the Fisher argument that only a tax on consumption would be a true income tax and that the ordinary income tax constitutes a double tax on savings. This argument places greater weight on savings than the market does, since the market knows all about the fructifying power of saving and allocates its expenditures accordingly. The problem we have to face here is this: Would such a tax as Fisher proposes actually have the intended effect—would it tax consumption only?

Let us consider a Mr. Jones, with a yearly income of 100 gold ounces. During the year, he spends 90 percent, or 90 ounces, on consumption and saves 10 percent, or 10 ounces. If the government imposes a 20-percent income tax upon him, he must pay 20 ounces at the end of the year. Assuming that his time-preference schedule remains the same (and setting aside the fact that there will be an increased proportion spent on consumption because an individual with fewer money assets has a higher time-preference rate), the ratio of his consumption to investment will still be 90:10. Jones will now spend 72 ounces on consumption and eight on investment.

Now, suppose that instead of an income tax, the government levies a 20-percent annual tax on consumption. Fisher maintained that such a tax would be levied only on consumption. But this is incorrect, since savings-investment is based solely on the possibility of future consumption. Since future consumption will also be taxed, in equilibrium, at the same rate as present consumption, it is evident that saving does not receive any special encouragement.33 Even if it were desirable for the government to encourage saving at the expense of consumption, taxing consumption would not do so. Since future and present consumption will be taxed equally, there will be no shift in favor of savings. In fact, there will be a shift in favor of consumption to the extent that a diminished amount of money causes an increase in the rate of preference for present goods. Setting aside this shift, his loss of funds will cause him to reallocate and reduce his savings as well as his consumption. Any payment of funds to the government necessarily reduces the net income remaining to him, and, since his time preference remains the same, he reduces his savings and his consumption proportionately.

It will help to see how this works arithmetically. We may use the following simple equation to sum up Jones’ position:

(1) Net Income = Gross Income – Tax
(2) Consumption = .90 Net Income
(3) Tax = .20 Consumption

With Gross Income equal to 100, and solving for these three equations, we get this result: Net Income = 85, Tax = 15, Consumption = 76.

We may now sum up in the following tabulation what happened to Jones under an income tax and under a consumption tax:

We thus see this important truth: A consumption tax is always shifted so as to become an income tax, though at a lower rate. In fact, the 20-percent consumption tax becomes equivalent to a 15-percent income tax. This is a very important argument against the plan. Fisher’s attempt to tax consumption alone must fail; the tax is shifted by the individual until it becomes an income tax, albeit at a lower rate than the equivalent income tax.

Thus, the rather startling conclusion is reached in our analysis that there can be no tax on consumption alone; all consumption taxes resolve themselves in one way or another into taxes on incomes. Of course, as is true of the direct consumption tax, the effect of the rate is discounted. And here perhaps lies a clue to the relative predilection that free-market economists have shown toward consumption taxes. Their charm, in the final analysis, consists in the discounting—in the fact that the same rate in a consumption tax has the effect of a lower rate of income tax. The tax burden on society and the market is lower.34 This reduction of the tax burden may be a very commendable objective, but it should be stated as such, and it should be realized that the problem lies not so much in the type of tax levied as in the over-all burden of taxes on individuals in the society.

We must now modify our conclusions by admitting the case of dishoarding or dissaving, which we had ruled out of the discussion. To the extent that dishoarding occurs, consumption is tapped rather than income, for the dissaver consumes out of previously accumulated wealth, and not out of current income. The Fisher tax would thus tap spending out of accumulated wealth, which would remain untaxed by ordinary income taxation.

• 24Some writers have pointed out that the penalty lowers future consumption from what it would have been, reducing the supply of goods and raising prices to consumers. This can hardly be called “shifting,” however, but is rather a manifestation of the ultimate effect of the tax in reducing consumer standards of living from the free-market level.
• 25It must not be inferred that the present author is an advocate of uniform taxation. Uniformity, in fact, will be sharply criticized below as an ideal impossible of attainment. (An ethical goal absolutely impossible of attainment is an absurd goal; to this extent we may engage, not in ethical exhortation, but in praxeological criticism of the possibility of realizing certain ethical goals.) However, it is analytically more convenient to treat various types of income taxation in relation to uniform treatment of all income.
• 26For the sake of convenience, we are assuming that this income is pure profit, and that interest income has already been disposed of. Only pure profit increases capital value, for in the evenly rotating economy there will be no net savings, and the interest income will just pay for maintaining the capital income structure intact.
• 27For a discussion of taxation on accumulated capital, see below.
• 28See Due, Government Finance, p. 146.
• 29Another problem in levying a tax on accrued capital gains is that the income is not realized in money directly. Uniform taxation of income in kind, as well as of psychic income, faces insuperable problems, as will be seen below. Just as there may be taxes on the imputed monetary equivalents of income in kind, however, there may also be taxes on accrued capital gains.
• 30Harold M. Groves, Financing Government (New York: Henry Holt, 1939), p. 181.
• 31Irregular income poses the same problem as irregular realized capital gain. The difficulty can be met in both cases by the suggested solution of averaging income over several years and paying taxes annually on the average.
• 32Fisher and Fisher, Constructive Income Taxation, passim.
• 33Neither does hoarding receive any special encouragement, since hoarding must finally eventuate in consumption. It is true that keeping cash balances itself yields a benefit, but the basis for such balances is always the prospect of future consumption.
• 34In the same way, the charm of the sales tax lies in the fact that it cannot be progressive, thus reducing the burden of income taxation on the upper groups.

The receipt of gifts has often been considered simple income. It should be obvious, however, that the recipient produced nothing in exchange for the money received; in fact, it is not an income from current production at all, but a transfer of ownership of accumulated capital. Any tax on the receipt of gifts, then, is a tax on capital. This is particularly true of inheritances, where the aggregation of capital is shifted to an heir, and the gift clearly does not come from current income. An inheritance tax, therefore, is a pure tax on capital. Its impact is particularly devastating because (a) large sums will be involved, since at some point within a few generations every piece of property must pass to heirs, and (b) the prospect of an inheritance tax destroys the incentive and the power to save and build up a family competence. The inheritance tax is perhaps the most devastating example of a pure tax on capital.

A tax on gifts and bequests has the further effect of penalizing charity and the preservation of family ties. It is ironic that some of those most ardent in advocating taxation of gifts and bequests are the first to assert that there would never be “enough” charity were the free market left to its own devices.

A property tax is a tax levied on the value of property and hence on accumulated capital. There are many problems peculiar to property taxation. In the first place, the tax depends on an assessment of the value of property, and the rate of tax is applied to this assessed value. But since an actual sale of property has usually not taken place, there is no way for assessments to be made accurately. Since all assessments are arbitrary, the road is open for favoritism, collusion, and bribery in making them.

Another weakness of current property taxation is that it taxes doubly both “real” and “intangible” property. The property tax adds “real” and “intangible” property assessments together; thus, the bondholders’ equity in property is added to the amount of the debtors’ liability. Property under debt is therefore doubly taxed as against other property. If A and B each own a piece of property worth $10,000, but C also holds a bond worth $6,000 on B’s property, the latter is assessed at a total of $16,000 and taxed accordingly.35 Thus, the use of the credit system is penalized, and the rate of interest paid to creditors must be raised to allow for the extra penalty.

One peculiarity of the property tax is that it attaches to the property itself rather than to the person who owns it. As a result, the tax is shifted on the market in a special way known as tax capitalization. Suppose, for example, that the social time-preference rate, or pure rate of interest, is 5 percent. Five percent is earned on all investments in equilibrium, and the rate tends to 5 percent as equilibrium is reached. Suppose a property tax is levied on one particular property or set of properties, e.g., on a house worth $10,000. Before this tax was imposed, the owner earned $500 annually on the property. An annual tax of 1 percent is now levied, forcing the owner to pay $100 per year to the government. What will happen now? As it stands, the owner will earn $400 per year on his investment. The net return on the investment will now be 4 percent. Clearly, no one will continue to invest at 4 percent in this property when he can earn 5 percent elsewhere. What will happen? The owner will not be able to shift his tax forward by raising the rental value of the property. The property’s earnings are determined by its discounted marginal value productivity, and the tax on the property does not increase its merits or earning power. In fact, the reverse occurs: the tax lowers the capital value of the property to enable owners to earn a 5-percent return. The market drive toward uniformity of interest return pushes the capital value of the property down to enable a return on investment. The capital value of the property will fall to $8,333, so that future returns will be 5 percent.36

In the long run, this process of reducing capital value is imputed backward, falling mainly on the owners of ground land. Suppose a property tax is levied on a capital good or a set of capital goods. Income to a capital good is resolvable into wages, interest, profit, and rental to ground land. A lower capital value of capital goods would shift resources elsewhere; workers, confronted with lower wages in producing this particular good, would shift to a better-paying job; capitalists would invest in a more remunerative field; and so forth. As a result, workers and entrepreneurs would largely be able to slough off the burden of the property tax, the former suffering to the extent that their original DMVP was higher here than in the next-highest-paying occupations. Consumers would, of course, suffer from a coerced misallocation of resources. The man bearing the major burden, then, is the owner of ground land; therefore, the process of tax capitalization applies most fully to a property tax upon ground land. The incidence falls on the owner of the “original” ground land, i.e., the owner at the time the tax is first imposed. For not only does the landlord pay the annual tax (a tax he cannot shift) so long as he is the owner, but he also suffers a loss in capital value. If Mr. Smith is the owner of the above property, not only does he pay $83 per year in taxes, but the capital value of his property also falls from $10,000 to $8,333. Smith openly absorbs the loss when he sells the property.

What, however, of the succeeding owners? They buy the property at $8,333 and earn a steady 5-percent interest, although they continue to pay $83 a year to the government. The expectation of the tax payment attached to the property, therefore, has been capitalized by the market and taken into account in arriving at its capital value. As a result, the future owners are able to shift the entire incidence of the property tax to the original owner; they do not really “pay” the tax in the sense that they bear its burden.

Tax capitalization is an instance of a process by which the market adjusts to burdens placed upon it. Those whom the government wanted to pay the burden can avoid doing so because of the market’s resilience in adjusting to new impositions. The original owners of ground land, however, are especially burdened by a property tax.

Some writers argue that, where tax capitalization has taken place, it would be unjust for the government to lower or remove the tax because such an action would grant a “free gift” to the current owners of property, who will receive a counterbalancing increase in its capital value. This is a curious argument. It rests on a fallacious identification of the removal of a burden with a subsidy. The former, however, is a move toward free-market conditions, whereas the latter is a move away from such conditions. Furthermore, the property tax, while not burdening future owners, depresses the capital value of the property below what it would be on the free market, and therefore discourages the employment of resources in this property. Removal of the property tax would reallocate resources to the advantage of the consumers.

Tax capitalization and its incidence on owners of ground land occur only where the property tax is partial rather than universal—on some pieces of property rather than all. A truly general property tax will reduce the rate of income earned from all investments and thereby reduce the rate of interest instead of the capital value. In that case, the interest return of both the original owner and later owners is reduced equally, and there is no extra burden on the original owner.

A general, uniform property tax on all property values, then, will, like an income tax, reduce the interest return throughout the economy. This will penalize saving, thereby reducing capital investment below what it would have been and depressing real wage rates further below their free-market level.37

Finally, a property tax necessarily distorts the allocation of resources in production. It penalizes those lines of production in which capital equipment per sales dollar is large and causes resources to shift from these to less “capitalistic” fields. Thus, investment in higher-order productive processes is discouraged, and the standard of living lowered. Individuals will invest less in housing, which bears a relatively heavy property tax burden, and shift instead to less durable consumers’ goods, thus distorting production and injuring consumer satisfaction. In practice, the property tax tends to be uneven from one line and location to another. Of course, geographic differences in property taxation, in impelling resources to escape heavy tax rates,38 will distort the location of production by driving it from those areas that would maximize consumer satisfaction.

• 35See Groves, Financing Government, p. 64.
• 36The final capital value is not $8,000, since the property tax is levied at 1 percent of the final value. The tax does not remain at 1 percent of the original capital value of $10,000. The capital value will fall to $8,333. Property tax payment will be $83, net annual return will be $417, and an annual rate of return of 5 percent on the capital of $8,333.
      The algebraic formula for arriving at this result is as follows: If C is the capital value to be determined, i is the rate of interest, and R the annual rent from the property, then, when no tax enters into the picture:
  iC = R
  When a property tax is levied, then the net return is the rent minus the annual tax liability, T, or:
       iC = R – T
  In this property tax, we postulate a fixed rate on the value of the property, so that:
       iC = R – tC,
  where t equals the tax rate on the value of the property.
  Transposing,
  C = R/i + t; the new capital value equals the annual rent divided by the interest rate plus the tax rate. Consequently, the capital value is driven down below its original sum, the higher are (a) the interest rate and (b) the tax rate.
• 37On tax-capitalization, see Seligman, Shifting and Incidence of Taxation, pp. 181–85, 261–64. See also Due, Government Financing, pp. 382–86.
• 38This distortion of location would result from all other forms of taxes as well. Thus, a higher income-tax rate in region A than in region B would induce workers to shift from A to B, in order to equalize net wage rates after taxes. The location of production is distorted as compared with the free market.

Although a tax on individual wealth has not been tried in practice, it offers an interesting topic for analysis. Such a tax would be imposed on individuals instead of on their property and would levy a certain percentage of their total net wealth, excluding liabilities. In its directness, it would be similar to the income tax and to Fisher’s proposed consumption tax. A tax of this kind would constitute a pure tax on capital, and would include in its grasp cash balances, which escape property taxation. It would avoid many difficulties of a property tax, such as double taxation of real and tangible property and the inclusion of debts as property. However, it would still face the impossibility of accurately assessing property values.

A tax on individual wealth could not be capitalized, since the tax would not be attached to a property, where it could be discounted by the market. Like an individual income tax, it could not be shifted, although it would have important effects. Since the tax would be paid out of regular income, it would have the effect of an income tax in reducing private funds and penalizing savings-investment; but it would also have the further effect of taxing accumulated capital.

How much accumulated capital would be taken by the tax depends on the concrete data and the valuations of the specific individuals. Let us postulate, for example, two individuals: Smith and Robinson. Each has an accumulated wealth of $100,000. Smith, however, also earns $50,000 a year, and Robinson (because of retirement or other reasons) earns only $1,000 a year. Suppose the government levies a 10-percent annual tax on an individual’s wealth. Smith might be able to pay the $10,000 a year out of his regular income, without reducing his accumulated wealth, although it seems clear that, since his tax liability is reduced thereby, he will want to reduce his wealth as much as possible. Robinson, on the other hand, must pay the tax by selling his assets, thereby reducing his accumulated wealth.

It is clear that the wealth tax levies a heavy penalty on accumulated wealth and that therefore the effect of the tax will be to slash accumulated capital. No quicker route could be found to promote capital consumption and general impoverishment than to penalize the accumulation of capital. Only our heritage of accumulated capital differentiates our civilization and living standards from those of primitive man, and a tax on wealth would speedily work to eliminate this difference. The fact that a wealth tax could not be capitalized means that the market could not, as in the case of the property tax, reduce and cushion its effect after the impact of the initial blow.

For centuries before the science of economics was developed, men searched for criteria of the “just price.” Of all the innumerable, almost infinite possibilities among the myriads of prices daily determined, what pattern should be considered as “just”? Gradually it came to be realized that there is no quantitative criterion of justice that can be objectively determined. Suppose that the price of eggs is 50¢ per dozen, what is the “just price”? It is clear, even to those (like the present writer) who believe in the possibility of a rational ethics, that no possible ethical philosophy or science can yield a quantitative measure or criterion of justice. If Professor X says that the “just” price of eggs is 45¢, and Professor Y says it is 85¢, no philosophical principle can decide between them. Even the most fervent antiutilitarian will have to concede this point. The various contentions all become purely arbitrary whim.

Economics, by tracing the ordered pattern of the voluntary exchange process, has made it clear that the only possible objective criterion for the just price is the market price. For the market price is, at every moment, determined by the voluntary, mutually agreed-upon actions of all the participants in the market. It is the objective resultant of every individual’s subjective valuations and voluntary actions, and is therefore the only existent objective criterion for “quantitative justice” in pricing.

Practically nobody now searches explicitly for the “just price,” and it is generally recognized that any ethical criticisms must be leveled qualitatively against the values of consumers, not against the quantitative price-structure that the market establishes on the basis of these values. The market price is the just price, given the pattern of consumer preferences. Furthermore, this just price is the concrete, actual market price, not equilibrium price, which can never be established in the real world, nor the “competitive price,” which is an imaginary figment.

If the search for the just price has virtually ended in the pages of economic works, why does the quest for a “just tax” continue with unabated vigor? Why do economists, severely scientific in their volumes, suddenly become ad hoc ethicists when the question of taxation is raised? In no other area of his subject does the economist become more grandiosely ethical.

There is no objection at all to discussion of ethical concepts when they are needed, provided that the economist realizes always (a) that economics can establish no ethical principles by itself—that it can only furnish existential laws to the ethicist or citizen as data; and (b) that any importation of ethics must be grounded on a consistent, coherent set of ethical principles, and not simply be slipped in ad hoc in the spirit of “well, everyone must agree to this. ...” Bland assumptions of universal agreement are one of the most irritating bad habits of the economist-turned-ethicist.

This book does not attempt to establish ethical principles. It does, however, refute ethical principles to the extent that they are insinuated, ad hoc and unanalyzed, into economic treatises. An example is the common quest for “canons of justice” in taxation. The prime objection to these “canons” is that the writers have first to establish the justice of taxation itself. If this cannot be proven, and so far it has not been, then it is clearly idle to look for the “just tax.” If taxation itself is unjust, then it is clear that no allocation of its burdens, however ingenious, can be declared just. This book sets forth no doctrines on the justice or injustice of taxation. But we do exhort economists either to forget about the problem of the “just tax” or, at least, to develop a comprehensive ethical system before they tackle this problem again.

Why do not economists abandon the search for the “just tax” as they abandoned the quest for the “just price”? One reason is that doing so may have unwelcome implications for them. The “just price” was abandoned in favor of the market price. Can the “just tax” be abandoned in favor of the market tax? Clearly not, for on the market there is no taxation, and therefore no tax can be established that will duplicate market patterns. As will be seen further below, there is no such thing as a “neutral tax”—a tax that will leave the market free and undisturbed—just as there is no such thing as neutral money. Economists and others may try to approximate neutrality, in the hopes of disturbing the market as little as possible, but they can never fully succeed.

Even the simplest maxims must not be taken for granted. Two centuries ago, Adam Smith laid down four canons of justice in taxation that economists have parroted ever since.60 One of them deals with the distribution of the burden of taxation, and this will be treated in detail below. Perhaps the most “obvious” was Smith’s injunction that costs of collection be kept to a “minimum” and that taxes be levied with this principle in mind.

An obvious and harmless maxim? Certainly not; this “canon of justice” is not obvious at all. For the bureaucrat employed in tax collection will tend to favor a tax with high administrative costs, thereby necessitating more extensive bureaucratic employment. Why should we call the bureaucrat obviously wrong? The answer is that he is not, and that to call him “wrong” it is necessary to engage in an ethical analysis that no economist has bothered to undertake.

A further point: if the tax is unjust on other grounds, it may be more just to have high administrative costs, for then there will be less chance that the tax will be fully collected. If it is easy to collect the tax, then the tax may do more damage to the economic system and cause more distortion of the market economy.

The same point might be made about another of Smith’s canons: that a tax should be levied so that payment is convenient. Here again, this maxim seems obvious, and there is certainly much truth in it. But someone may urge that a tax should be made inconvenient to induce people to rebel and force a lowering of the level of taxation. Indeed, this used to be one of the prime arguments of “conservatives” for an income tax as opposed to an indirect tax. The validity of this argument is beside the point; the point is that it is not self-evidently wrong, and therefore this canon is no more simple and obvious than the others.

Smith’s final canon of just taxation is that the tax be certain and not arbitrary, so that the taxpayer knows what he will pay. Here again, further analysis demonstrates that this is by no means obvious. Some may argue that uncertainty benefits the taxpayer, for it makes the requirement more flexible and permits bribery of the tax collector. This benefits the taxpayer to the extent that the price of the bribe is less than the tax that he would otherwise have to pay. Furthermore, there is no way of establishing long-range certainty, for the tax rates may be changed by the government at any time. In the long run, certainty of taxation is an impossible goal.

A similar argument may be levelled against the view that taxes “should” be difficult to evade. If a tax is onerous and unjust, evasion might be highly beneficial to the economy, and moral to boot.

Thus, none of these supposedly self-evident canons of taxation is a canon at all. From some ethical points of view they are correct, from others they are incorrect. Economics cannot decide between them.

• 60Adam Smith, The Wealth of Nations (New York: Modern Library, 1937), pp. 777–79. See also Hunter and Allen, Principles of Public Finance, pp. 137–40.

Up to this point, we have been discussing taxation as it is levied on any given individual or firm. Now we must turn to another aspect: the distribution of the burden of taxes among the people in the economy. Most of the search for “justice” in taxation has involved the problem of the “just distribution” of this burden.

Various proposed canons of justice will be discussed in this section, followed by analysis of the economic effects of tax distribution.

A few writers, disturbed by the compulsion necessary to the existence of taxation, have advocated that governments be financed, not by taxation, but by some form of voluntary contribution. Such voluntary contribution systems could take various forms. One was the method relied on by the old city-state of Hamburg and other communities—voluntary gifts to the government. President William F. Warren of Boston University, in his essay, “Tax Exemption the Road to Tax Abolition,” described his experience in one of these communities:

For five years it was the good fortune of the present writer to be domiciled in one of these communities. Incredible as it may seem to believers in the necessity of a legal enforcement of taxes by pains and penalties, he was for that period ... his own assessor and his own tax-gatherer. In common with the other citizens, he was invited, without sworn statement or declaration, to make such contribution to the public charges as seemed to himself just and equal. That sum, uncounted by any official, unknown to any but himself, he was asked to drop with his own hand into a strong public chest; on doing which his name was checked off the list of contributors. ... Every citizen felt a noble pride in such immunity from prying assessors and rude constables. Every annual call of the authorities on that community was honored to the full.82

The gift method, however, presents some serious difficulties. In particular, it continues that disjunction between payment and receipt of service which constitutes one of the great defects of a taxing system. Under taxation, payment is severed from receipt of service, in striking contrast to the market where payment and service are correlative. The voluntary gift method perpetuates this disjunction. As a result, A, B, and C continue to receive the government’s defense service even if they paid nothing for it, and only D and E contributed. D’s and E’s contributions, furthermore, may be disproportionate. It is true that this is the system of voluntary charity on the market. But charity flows from the more to the less wealthy and able; it does not constitute an efficient method for organizing the general sale of a service. Automobiles, clothes, etc., are sold on the market on a regular uniform-price basis and are not indiscriminately given to some on the basis of gifts received from others. Under the gift system people will tend to demand far more defense service from the government than they are willing to pay for; and the voluntary contributors, getting no direct reward for their money, will tend to reduce their payment. In short, where service (such as defense) flows to people regardless of payment, there will tend to be excessive demands for service, and an insufficient supply of funds to sustain it.

When the advocates of taxation, therefore, contend that a voluntary society could never efficiently finance defense service because people would evade payment, they are correct insofar as their strictures apply to the gift method of finance. The gift method, however, hardly exhausts the financing methods of the purely free market.

A step in the direction of greater efficiency would have the defense agency charging a set price instead of accepting haphazard amounts varying from the very small to the very large, but continuing to supply defense indiscriminately. Of course, the agency would not refuse gifts for general purposes or for granting a supply of defense service to poor people. But it would charge some minimum price commensurate with the cost of its service. One such method is a voting tax, now known as a poll tax.83 A poll tax, or voting tax, is not really a “tax” at all; it is only a price charged for participating in the State organization.84 Only those who voluntarily vote for State officials, i.e., who participate in the State machinery, are required to pay the tax. If all the State’s revenues were derived from poll taxes, therefore, this would not be a system of taxation at all, but rather voluntary contributions in payment for the right to participate in the State’s machinery. The voting tax would be an improvement over the gift method because it would charge a certain uniform or minimal amount.

To the proposal to finance all government revenues from poll taxes it has been objected that practically no one would vote under these conditions. This is perhaps an accurate prediction, but curiously the critics of the poll tax never pursue their analysis beyond this point. It is clear that this reveals something very important about the nature of the voting process. Voting is a highly marginal activity because (a) the voter obtains no direct benefits from his act of voting, and (b) his aliquot power over the final decision is so small that his abstention from voting would make no appreciable difference to the final outcome. In short, in contrast to all other choices a man may make, in political voting he has practically no power over the outcome, and the outcome would make little direct difference to him anyway. It is no wonder that well over half the eligible American voters persistently refuse to take part in the annual November balloting. This discussion also illuminates a puzzling phenomenon in American political life—the constant exhortation by politicians of all parties for people to vote: “We don’t care how you vote, but vote!” is a standard political slogan.85 On its face, it makes little sense, for one would think that at least one of the parties would see advantages in a small vote. But it does make a great deal of sense when we realize the enormous desire of politicians of all parties to make it appear that the people have given them a “mandate” in the election—that all the democratic shibboleths about “representing the people,” etc., are true.

The reason for the relative triviality of voting is, once again, the disjunction between voting and payment, on the one hand, and benefit on the other. The poll tax gives rise to the same problem. The voter, with or without paying a poll tax, receives no more benefit in protection than the nonvoter. Consequently, people will refuse to vote in droves under a single poll-tax scheme, and everyone will demand the use of the artificially free defense resources.

Both the gift and the voting-tax methods of voluntary financing of government, therefore, must be discarded as inefficient. A third method has been proposed, which we can best call by the paradoxical name voluntary taxation. The plan envisioned is as follows: Every land area would, as now, be governed by one monopolistic State. The State’s officials would be chosen by democratic voting, as at present. The State would set a uniform price, or perhaps a set of cost prices, for protective services, and it would be left to each individual to make a voluntary choice whether to pay or not to pay the price. If he pays the price, he receives the benefit of governmental defense service; if he does not, he goes unprotected.86 The leading “voluntary taxationists” have been Auberon Herbert, his associate, J. Greevz Fisher, and (sometimes) Gustave de Molinari. The same position is found earlier, to a far less developed extent, in the early editions of Herbert Spencer’s Social Statics, particularly his chapter on the “Right to Ignore the State,” and in Thoreau’s Essay on Civil Disobedience.87

The voluntary taxation method preserves a voluntary system, is (or appears to be) neutral vis-à-vis the market, and eliminates the payment-benefit disjunction. And yet this proposal has several important defects. Its most serious flaw is inconsistency. For the voluntary taxationists aim at establishing a system in which no one is coerced who is not himself an invader of the person or property of others. Hence their complete elimination of taxation. But, although they eliminate the compulsion to subscribe to the government defense monopoly, they yet retain that monopoly. They are therefore faced with the problem: Would they use force to compel people not to use a freely competing defense agency within the same geographic area? The voluntary taxationists have never attempted to answer this problem; they have rather stubbornly assumed that no one would set up a competing defense agency within a State’s territorial limits. And yet, if people are free to pay or not to pay “taxes,” it is obvious that some people will not simply refuse to pay for all protection. Dissatisfied with the quality of defense they receive from the government, or with the price they must pay, they will elect to form a competing defense agency or “government” within the area and subscribe to it. The voluntary taxation system is thus impossible of attainment because it would be in unstable equilibrium. If the government elected to outlaw all competing defense agencies, it would no longer function as the voluntary society sought by its proponents. It would not force payment of taxes, but it would say to the citizens: “You are free to accept and pay for our protection or to abstain; but you are not free to purchase defense from a competing agency.” This is not a free market; this is a compulsory monopoly, once again a grant of monopoly privilege by the State to itself. Such a monopoly would be far less efficient than a freely competitive system; hence, its costs would be higher, its service poorer. It would clearly not be neutral to the market.

On the other hand, if the government did permit free competition in defense service, there would soon no longer be a central government over the territory. Defense agencies, police and judicial, would compete with one another in the same uncoerced manner as the producers of any other service on the market. The prices would be lower, the service more efficient. And, for the first and only time, the defense system would then be neutral in relation to the market. It would be neutral because it would be a part of the market itself! Defense service would at last be made fully marketable. No longer would anyone be able to point to one particular building or set of buildings, one uniform or set of uniforms, as representing “our government.”

While “the government” would cease to exist, the same cannot be said for a constitution or a rule of law, which, in fact, would take on in the free society a far more important function than at present. For the freely competing judicial agencies would have to be guided by a body of absolute law to enable them to distinguish objectively between defense and invasion. This law, embodying elaborations upon the basic injunction to defend person and property from acts of invasion, would be codified in the basic legal code. Failure to establish such a code of law would tend to break down the free market, for then defense against invasion could not be adequately achieved. On the other hand, those neo-Tolstoyan nonresisters who refuse to employ violence even for defense would not themselves be forced into any relationship with the defense agencies.

Thus, if a government based on voluntary taxation permits free competition, the result will be the purely free-market system outlined in chapter 1 above. The previous government would now simply be one competing defense agency among many on the market. It would, in fact, be competing at a severe disadvantage, having been established on the principle of “democratic voting.” Looked at as a market phenomenon, “democratic voting” (one vote per person) is simply the method of the consumer “co-operative.” Empirically, it has been demonstrated time and again that co-operatives cannot compete successfully against stock-owned companies, especially when both are equal before the law. There is no reason to believe that cooperatives for defense would be any more efficient. Hence, we may expect the old co-operative government to “wither away” through loss of customers on the market, while joint-stock (i.e., corporate) defense agencies would become the prevailing market form.88

• 82Dr. Warren’s article appeared in the Boston University Year Book for 1876. The board of the Council of the University endorsed the essay in these words:
  In place of the further extent of taxation advocated by many, the essay proposes a far more imposing reform, the general abolition of all compulsory taxes. It is hoped that the comparative novelty of the proposition may not deter practical men from a thoughtful study of the paper. (See the Boston University Year Book III (1876), pp. 17–38)Both quotations may be found in Sidney H. Morse, “Chips from My Studio,” The Radical Review, May, 1877, pp. 190–92. See also Adam Smith, Wealth of Nations, pp. 801–03; Francis A. Walker, Political Economy (New York: Henry Holt, 1911), pp. 475–76. Smith, in one of his most sensible canons, declared:
  In a small republic, where the people have entire confidence in their magistrates and are convinced of the necessity of the tax for the support of the state, and believe that it will be faithfully applied to that purpose, such conscientious and voluntary payment may sometimes be expected. (Smith, Wealth of Nations, p. 80
• 83The current poll tax began simply as a head tax, but in practice it is enforced only as a requirement for voting. It has therefore become a voting tax.
• 84See below on fees charged for government service.
• 85Voting, like taxation, is another activity generally phrased in terms of “duty” rather than benefit. The call to “duty” is as praxeologically unsound as the call to sacrifice and generally amounts to the same thing. For both exhortations tacitly admit that the actor will derive little or no benefit from his action. Further, the invocation of duty or sacrifice implies that someone else is going to receive the sacrifice or the payment of the “obligation”—and often that someone is the exhorter himself.
• 86We are assuming that the government will confine its use of force to defense, i.e., will pursue a strictly laissez-faire policy. Theoretically, it is possible that a government may get all its revenue from voluntary contribution, and yet pursue a highly coercive, interventionist policy in other areas of the market. The possibility is so remote in practice, however, that we may disregard it here. It is highly unlikely that a government coercive in other ways would not take immediate steps to see that its revenues are assured by coercion. Its own revenue is always the State’s prime concern. (Note the very heavy penalties for income-tax evasion and counterfeiting of government paper money.)
• 87Spencer, Social Statics; Herbert and Levy, Taxation and Anarchism; and Molinari, Society of Tomorrow. At other times, however, Molinari adopted the pure free-market position. Thus, see what may be the first developed outline of the purely libertarian system in Gustave de Molinari, “De la production de la sécurité,” Journal des Economistes, February, 1849, pp. 277–90, and Molinari, “Onzième soirée” in Les soirées de la rue Saint Lazare (Paris, 1849).
• 88These corporations would not, of course, need any charter from a government but would “charter” themselves in accordance with the ways in which their owners decided to pool their capital. They could announce their limited liability in advance, and then all their creditors would be put amply on guard.
       There is a strong a priori reason for believing that corporations will be superior to cooperatives in any given situation. For if each owner receives only one vote regardless of how much money he has invested in a project (and earnings are divided in the same way), there is no incentive to invest more than the next man; in fact, every incentive is the other way. This hampering of investment militates strongly against the cooperative form.