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.

(a) Equality before the law: tax exemption

Uniformity of treatment has been upheld as an ideal by almost all writers. This ideal is supposed to be implicit in the concept of “equality before the law,” which is best expressed in the phrase, “Like to be treated alike.” To most economists this ideal has seemed self-evident, and the only problems considered have been the practical ones of defining exactly when one person is “like” someone else (problems that, we shall see below, are insuperable).

All these economists adopt the goal of uniformity regardless of what principle of “likeness” they may hold. Thus, the man who believes that everyone should be taxed in accordance with his “ability to pay” also believes that everyone with the same ability should be taxed equally; he who believes that each should be taxed proportionately to his income also holds that everyone with the same income should pay the same tax; etc. In this way, the ideal of uniformity pervades the literature on taxation.

Yet this canon is by no means obvious, for it seems clear that the justice of equality of treatment depends first of all on the justice of the treatment itself. Suppose, for example, that Jones, with his retinue, proposes to enslave a group of people. Are we to maintain that “justice” requires that each be enslaved equally? And suppose that someone has the good fortune to escape. Are we to condemn him for evading the equality of justice meted out to his fellows? It is obvious that equality of treatment is no canon of justice whatever. If a measure is unjust, then it is just that it have as little general effect as possible. Equality of unjust treatment can never be upheld as an ideal of justice. Therefore, he who maintains that a tax be imposed equally on all must first establish the justice of the tax itself.

Many writers denounce tax exemptions and levy their fire at the tax-exempt, particularly those instrumental in obtaining the exemptions for themselves. These writers include those advocates of the free market who treat a tax exemption as a special privilege and attack it as equivalent to a subsidy and therefore inconsistent with the free market. Yet an exemption from taxation or any other burden is not equivalent to a subsidy. There is a key difference. In the latter case a man is receiving a special grant of privilege wrested from his fellowmen; in the former he is escaping a burden imposed on other men. Whereas the one is done at the expense of his fellowmen, the other is not. For in the former case, the grantee is participating in the acquisition of loot; in the latter, he escapes payment of tribute to the looters. To blame him for escaping is equivalent to blaming the slave for fleeing his master. It is clear that if a certain burden is unjust, blame should be levied, not on the man who escapes the burden, but on the man or men who impose it in the first place. If a tax is in fact unjust, and some are exempt from it, the hue and cry should not be to extend the tax to everyone, but on the contrary to extend the exemption to everyone. The exemption itself cannot be considered unjust unless the tax or other burden is first established as just.

Thus, uniformity of treatment per se cannot be established as a canon of justice. A tax must first be proven just; if it is unjust, then uniformity is simply imposition of general injustice, and exemption is to be welcomed. Since the very fact of taxation is an interference with the free market, it is particularly incongruous and incorrect for advocates of a free market to advocate uniformity of taxation.

One of the major sources of confusion for economists and others who are in favor of the free market is that the free society has often been defined as a condition of “equality before the law,” or as “special privilege for none.” As a result, many have transferred these concepts to an attack on tax exemptions as a “special privilege” and a violation of the principle of “equality before the law.” As for the latter concept, it is, again, hardly a criterion of justice, for this depends on the justice of the law or “treatment” itself. It is this alleged justice, rather than equality, which is the primary feature of the free market. In fact, the free society is far better described by some such phrase as “equality of rights to defend person and property” or “equality of liberty” rather than by the vague, misleading expression “equality before the law.”61

In the literature on taxation there is much angry discussion about “loopholes,” the inference being that any income or area exempt from taxation must be brought quickly under its sway. Any failure to “plug loopholes” is treated as immoral. But, as Mises incisively asked:

What is a loophole? If the law does not punish a definite action or does not tax a definite thing, this is not a loophole. It is simply the law. ... The income tax exemptions in our income tax are not loopholes. ... Thanks to these loopholes this country is still a free country.62

(b) The impossibility of uniformity

Aside from these considerations, the ideal of uniformity is impossible to achieve. Let us confine our further discussion of uniformity to income taxation, for two reasons: (1) because the vast bulk of our taxation is income taxation; and (2) because, as we have seen, most other taxes boil down to income taxes anyway. A tax on consumption ends largely as a tax on income at a lower rate.

There are two basic reasons why uniformity of income taxation is an impossible goal. The first stems from the very nature of the State. We have seen, when discussing Calhoun’s analysis, that the State must separate society into two classes, or castes: the taxpaying caste and the tax-consuming caste. The tax consumers consist of the full-time bureaucracy and politicians in power, as well as the groups which receive net subsidies, i.e., which receive more from the government than they pay to the government. These include the receivers of government contracts and of government expenditures on goods and services produced in the private sector. It is not always easy to detect the net subsidized in practice, but this caste can always be conceptually identified.

Thus, when the government levies a tax on private incomes, the money is shifted from private people to the government, and the government’s money, whether expended for government consumption of goods and services, for salaries to bureaucrats, or as subsidies to privileged groups, returns to be spent in the economic system. It is clear that the tax-expenditure level must distort the expenditure pattern of the market and shift productive resources away from the pattern desired by the producers and toward that desired by the privileged. This distortion takes place in proportion to the amount of taxation.

If, for example, the government taxes funds that would have been spent on automobiles and itself spends them on arms, the arms industry and, in the long run, the specific factors in the arms industry become net tax consumers, while a special loss is inflicted on the automobile industry and ultimately on the factors specific to that industry. It is because of these complex relationships that, as we have mentioned, the identification in practice of the net subsidized may be difficult.

One thing we know without difficulty, however. Bureaucrats are net tax consumers. As we pointed out above, bureaucrats cannot pay taxes. Hence, it is inherently impossible for bureaucrats to pay income taxes uniformly with everyone else. And therefore the ideal of uniform income taxation for all is an impossible goal. We repeat that the bureaucrat who receives $8,000 a year income and then hands $1,500 back to the government is engaging in a mere bookkeeping transaction of no economic importance (aside from the waste of paper and records involved). For he does not and cannot pay taxes; he simply receives $6,500 a year from the tax fund.

If it is impossible to tax income uniformly because of the nature of the tax process itself, the attempt to do so also confronts another insuperable difficulty, that of trying to arrive at a cogent definition of “income.” Should taxable income include the imputed money value of services received in kind, such as farm produce grown on one’s own farm? What about imputed rent from living in one’s own house? Or the imputed services of a housewife? Regardless of which course is taken in any of these cases, a good argument can be made that the incomes included as taxable are not the correct ones. And if it is decided to impute the value of goods received in kind, the estimates must always be arbitrary, since the actual sales for money were not made.

A similar difficulty is raised by the question whether incomes should be averaged over several years. Businesses that suffer losses and reap profits are penalized as against those with steady incomes—unless, of course, the government subsidizes part of the loss. This may be corrected by permitting averaging of income over several years, but here again the problem is insoluble because there are only arbitrary ways of deciding the period of time to allow for averaging. If the income tax rate is “progressive,” i.e., if the rate increases as earnings increase, then failure to permit averaging penalizes the man with an erratic income. But again, to permit averaging will destroy the ideal of uniform current tax rates; furthermore, varying the period of averaging will vary the results.

We have seen that, in order to tax income only, it is necessary to correct for changes in the purchasing power of money when taxing capital gains. But once again, any index or factor of correction is purely arbitrary, and uniformity cannot be achieved because of the impossibility of securing general agreement on a definition of income.

For all these reasons, the goal of uniformity of taxation is an impossible one. It is not simply difficult to achieve in practice; it is conceptually impossible and self-contradictory. Surely any ethical goal that is conceptually impossible of achievement is an absurd goal, and therefore any movements in the direction of the goal are absurd as well.63 It is therefore legitimate, and even necessary, to engage in a logical (i.e., praxeological) critique of ethical goals and systems when they are relevant to economics.

Having analyzed the goal of uniformity of treatment, we turn now to the various principles that have been set forth to give content to the idea of uniformity, to answer the question: Uniform in respect to what? Should taxes be uniform as to “ability to pay,” or “sacrifice,” or “benefits received”? In other words, while most writers have rather unthinkingly granted that people in the same income bracket should pay the same tax, what principle should govern the distribution of income taxes between tax brackets? Should the man making $10,000 a year pay as much as, as much proportionately as, more than, more proportionately than, or less than, a man making $5,000 or $1,000 a year? In short, should people pay uniformly in accordance with their “ability to pay,” or sacrifice made, or some other principle?

• 61This discussion applies to Professor Hayek’s adoption of the “rule of law” as the basic political criterion. F.A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960).
• 62Mises, in Aaron Director, ed., Defense, Controls and Inflation (Chicago: University of Chicago Press, 1952), pp. 115–16.
• 63To say that an ethical goal is conceptually impossible is completely different from saying that its achievement is “unrealistic” because few people uphold it. The latter is by no means an argument against an ethical principle.
       Conceptual impossibility means that the goal could not be achieved even if everyone aimed at it. On the problem of “realism” in ethical goals, see the brilliant article by Clarence E. Philbrook, “‘Realism’ in Policy Espousal,” American Economic Review, December, 1953, pp. 846–59.

(a) The ambiguity of the concept

This principle states that people should pay taxes in accordance with their “ability to pay.” It is generally conceded that the concept of ability to pay is a highly ambiguous one and presents no sure guide for practical application.64 Most economists have employed the principle to support a program of proportional or progressive income taxation, but this would hardly suffice. It seems clear, for example, that a person’s accumulated wealth affects his ability to pay. A man earning $5,000 during a certain year probably has more ability to pay than a neighbor earning the same amount if he also has $50,000 in the bank while his neighbor has nothing. Yet a tax on accumulated capital would cause general impoverishment. No clear standard can be found to gauge “ability to pay.” Both wealth and income would have to be considered, medical expenses would have to be deducted, etc. But there is no precise criterion to be invoked, and the decision is necessarily arbitrary. Thus, should all or some proportion of medical bills be deducted? What about the expenses of childrearing? Or food, clothing, and shelter as necessary to consumer “maintenance”? Professor Due attempts to find a criterion for ability in “economic well-being,” but it should be clear that this concept, being even more subjective, is still more difficult to define.65

Adam Smith himself used the ability concept to support proportional income taxation (taxation at a constant percentage of income), but his argument is rather ambiguous and applies to the “benefit” principle as well as to “ability to pay.”66 Indeed, it is hard to see in precisely what sense ability to pay rises in proportion to income. Is a man earning $10,000 a year “equally able” to pay $2,000 as a man earning $1,000 to pay $200? Setting aside the basic qualifications of difference in wealth, medical expenses, etc., in what sense can “equal ability” be demonstrated? Attempting to define equal ability in such a way is a meaningless procedure.

McCulloch, in a famous passage, attacked progressiveness and defended proportionality of taxation:

The moment you abandon ... the cardinal principle of exacting from all individuals the same proportion of their income or their property, you are at sea without rudder or compass, and there is no amount of injustice or folly you may not commit.67

Seemingly plausible, this thesis is by no means self-evident. In what way is proportional taxation any less arbitrary than any given pattern of progressive taxation, i.e., where the rate of tax increases with income? There must be some principle that can justify proportionality; if this principle does not exist, then proportionality is no less arbitrary than any other taxing pattern. Various principles have been offered and will be considered below, but the point is that proportionality per se is neither more nor less sound than any other taxation.

One school of thought attempts to find a justification for a progressive tax via an ability-to-pay principle. This is the “faculty” approach of E.R.A. Seligman. This doctrine holds that the more money a person has, the relatively easier it is for him to acquire more. His power of obtaining money is supposed to increase as he has more: “A rich man may be said to be subject ... to a law of increasing returns.”68 Therefore, since his ability increases at a faster rate than his income, a progressive income tax is justified. This theory is simply invalid.69 Money does not “make money”; if it did, then a few people would by now own all the world’s wealth. To be earned money must continually be justifying itself in current service to consumers. Personal income, interest, profits, and rents are earned only in accordance with their current, not their past, services. The size of accumulated fortune is immaterial, and fortunes can be and are dissipated when their owners fail to reinvest them wisely in the service of consumers.

As Blum and Kalven point out, the Seligman thesis is utter nonsense when applied to personal services such as labor energy. It could only make sense when applied to income from property, i.e., investment in land or capital goods (or slaves, in a slave economy). But the return on capital is always tending toward uniformity, and any departures from uniformity are due to especially wise and farseeing investments (profits) or especially wasteful investments (losses). The Seligman thesis would fallaciously imply that the rates of return increase in proportion to the amount invested.

Another theory holds that ability to pay is proportionate to the “producer’s surplus” of an individual, i.e., his “economic rent,” or the amount of his income above the payment necessary for him to continue production. The consequences of taxation of site rent were noted above. The “necessary payments” to labor are clearly impossible to establish; if someone is asked by the tax authorities what his “minimum” wage is, what will prevent him from saying that any amount below the present wage will cause him to retire or to shift to another job? Who can prove differently? Furthermore, even if it could be determined, this “surplus” is hardly an indicator of ability to pay. A movie star may have practically zero surplus, for some other studio may be willing to bid almost as much as he makes now for his services, while a disabled ditch-digger may have a much greater “surplus” because no one else may be willing to hire him. Generally, in an advanced economy there is little “surplus” of this type, for the competition of the market will push alternative jobs and uses near to the factor’s discounted marginal value product in its present use. Hence, it would be impossible to tax any “surplus” over necessary payment from land or capital since none exists, and practically impossible to tax the “surplus” to labor since the existence of a sizable surplus is rare, impossible to determine, and, in any case, no criterion whatever of ability to pay.70

(b) The justice of the standard

The extremely popular ability-to-pay idea was sanctified by Adam Smith in his most important canon of taxation and has been accepted blindly ever since. While much criticism has been levelled at its inherent vagueness, hardly anyone has criticized the basic principle, despite the fact that no one has really grounded it in sound argument. Smith himself gave no reasoning to support this alleged principle, and few others have done so since. Due, in his text on public finance, simply accepts it because most people believe in it, thereby ignoring the possibility of any logical analysis of ethical principles.71

The only substantial attempt to give some rational support to the “ability-to-pay principle” rests on a strained comparison of tax payments to voluntary gifts to charitable organizations. Thus Groves writes: “ To hundreds of common enterprises (community chests, Red Cross, etc.) people are expected to contribute according to their means. Governments are one of these common enterprises fostered to serve the citizens as a group. ...”72 Seldom have more fallacies been packed into two sentences. In the first place, the government is not a common enterprise akin to the community chest. No one can resign from it. No one, on penalty of imprisonment, can come to the conclusion that this “charitable enterprise” is not doing its job properly and therefore stop his “contribution”; no one can simply lose interest and drop out. If, as will be seen further below, the State cannot be described as a business, engaged in selling services on the market, certainly it is ludicrous to equate it to a charitable organization. Government is the very negation of charity, for charity is uniquely an unbought gift, a freely flowing uncoerced act by the giver. The word “expected” in Groves’ phrase is misleading. No one is forced to give to any charity in which he is not interested or which he believes is not doing its job properly.

The contrast is even clearer in a phrase of Hunter and Allen’s:

Contributions to support the church or the community chest are expected, not on the basis of benefits which individual members receive from the organization, but upon the basis of their ability to con-tribute.73

But this is praxeologically invalid. The reason that anyone contributes voluntarily to a charity is precisely the benefit that he obtains from it. Yet benefit can be considered only in a subjective sense. It can never be measured. The fact of subjective gain, or benefit, from an act is deducible from the fact that it was performed. Each person making an exchange is deduced to have benefited (at least ex ante). Similarly, a person who makes a unilateral gift is deduced to have benefited (ex ante) from making the gift. If he did not benefit, he would not have made the gift. This is another indication that praxeology does not assume the existence of an “economic man,” for the benefit from an action may come either from a good or a service directly received in exchange, or simply from the knowledge that someone else will benefit from a gift. Gifts to charitable institutions, therefore, are made precisely on the basis of benefit to the giver, not on the basis of his “ability to pay.”

Furthermore, if we compare taxation with the market, we find no basis for adopting the “ability-to-pay” principle. On the contrary, the market price (generally considered the just price) is almost always uniform or tending toward uniformity. Market prices tend to obey the rule of one price throughout the entire market. Everyone pays an equal price for a good regardless of how much money he has or his “ability to pay.” Indeed, if the “ability-to-pay” principle pervaded the market, there would be no point in acquiring wealth, for everyone would have to pay more for a product in proportion to the money in his possession. Money incomes would be approximately equalized, and, in fact, there would be no point at all to acquiring money, since the purchasing power of a unit of money would never be definite but would drop, for any man, in proportion to the quantity of money he earns. A person with less money would simply find the purchasing power of a unit of his money rising accordingly. Therefore, unless trickery and black marketeering could evade the regulations, establishing the “ability-to-pay” principle for prices would wreck the market altogether. The wrecking of the market and the monetary economy would plunge society back to primitive living standards and, of course, eliminate a large part of the current world population, which is permitted to earn a subsistence living or higher by virtue of the existence of the modern, developed market.

It should be clear, moreover, that establishing equal incomes and wealth for all (e.g., by taxing all those over a certain standard of income and wealth, and subsidizing all those below that standard) would have the same effect, since there would be no point to anyone’s working for money. Those who enjoy performing labor will do so only “at play,” i.e., without obtaining a monetary return. Enforced equality of income and wealth, therefore, would return the economy to barbarism.

If taxes were to be patterned after market pricing, then, taxes would be levied equally (not proportionately) on everyone. As will be seen below, equal taxation differs in critical respects from market pricing but is a far closer approximation to it than is “ability-to-pay” taxation.

Finally, the “ability-to-pay” principle means precisely that the able are penalized, i.e., those most able in serving the wants of their fellow men. Penalizing ability in production and service diminishes the supply of the service—and in proportion to the extent of that ability. The result will be impoverishment, not only of the able, but of the rest of society, which benefits from their services.

The “ability-to-pay” principle, in short, cannot be simply assumed; if it is employed, it must be justified by logical argument, and this economists have yet to provide. Rather than being an evident rule of justice, the “ability-to-pay” principle resembles more the highwayman’s principle of taking where the taking is good.74

• 64See Walter J. Blum and Harry Kalven, Jr., The Uneasy Case for Progressive Taxation (Chicago: University of Chicago Press, 1963), pp. 64–68.
• 65Due, Government Finance, pp. 121ff.
• 66Said Smith:
  The subjects of every state ought to contribute toward the support of the government, as nearly as possible, in proportion of their respective abilities; that is, in proportion to the revenue which they respectively enjoy under protection of the state. The expense of government to the individuals of a great nation, is like the expense of management to the joint tenants of a great estate, who are all obliged to contribute to their respective interests in the estate. (Wealth of Nations, p. 777)
• 67J.R. McCulloch, A Treatise on the Principle and Practical Influence of Taxation and the Funding System (London, 1845), p. 142.
• 68E.R.A. Seligman, Progressive Taxation in Theory and Practice (2nd ed.; (New York: Macmillan & Co., 1908), pp. 291–92.
• 69For an excellent critique of the Seligman theory, see Blum and Kalven, Uneasy Case for Progressive Taxation, pp. 64–66.
• 70See ibid., pp. 67–68.
• 71Due, Government Finance, p. 122.
• 72Groves, Financing Government, p. 36.
• 73Hunter and Allen, Principles of Public Finance, pp. 190–91.
• 74See Chodorov, Out of Step, p. 237. See also Chodorov, From Solomon’s Yoke to the Income Tax (Hinsdale, Ill.: Henry Regnery, 1947), p. 11.

Another attempted criterion of just taxation was the subject of a flourishing literature for many decades, although it is now decidedly going out of fashion. The many variants of the “sacrifice” approach are akin to a subjective version of the “ability-to-pay” principle. They all rest on three general premises: (a) that the utility of a unit of money to an individual diminishes as his stock of money increases; (b) that these utilities can be compared interpersonally and thus can be summed up, subtracted, etc.; and (c) that everyone has the same utility-of-money schedule. The first premise is valid (but only in an ordinal sense), but the second and third are nonsensical. The marginal utility of money does diminish, but it is impossible to compare one person’s utilities with another, let alone believe that everyone’s valuations are identical. Utilities are not quantities, but subjective orders of preference. Any principle for distributing the tax burden that rests on such assumptions must therefore be declared fallacious. Happily, this truth is now generally established in the economic literature.75

Utility and “sacrifice” theory has generally been used to justify progressive taxation, although sometimes proportional taxation has been upheld on this ground. Briefly, a dollar is alleged to “mean less” or be worth less in utility to a “rich man” than to a “poor man” (“rich” or “poor” in income or wealth?), and therefore payment of a dollar by a rich man imposes less of a subjective sacrifice on him than on a poor man. Hence, the rich man should be taxed at a higher rate. Many “ability-to-pay” theories are really inverted sacrifice theories, since they are couched in the form of ability to make sacrifices.

Since the nub of the sacrifice theory—interpersonal comparisons of utility—is now generally discarded, we shall not spend much time discussing the sacrifice doctrine in detail.76 However, several aspects of this theory are of interest. The sacrifice theory divides into two main branches: (1) the equal-sacrifice principle and (2) the minimum-sacrifice principle. The former states that every man should sacrifice equally in paying taxes; the latter, that society as a whole should sacrifice the least amount. Both versions abandon completely the idea of government as a supplier of benefits and treat government and taxation as simply a burden, a sacrifice that must be borne in the best way we know how. Here we have a curious principle of justice indeed—based on adjustment to hurt. We are faced again with that pons asinorum that defeats all attempts to establish canons of justice for taxation—the problem of the justice of taxation itself. The proponent of the sacrifice theory, in realistically abandoning unproved assumptions of benefit from taxation, must face and then founder on the question: If taxation is pure hurt, why endure it at all?

The equal-sacrifice theory asks that equal hurt be imposed on all. As a criterion of justice, this is as untenable as asking for equal slavery. One interesting aspect of the equal-sacrifice theory, however, is that it does not necessarily imply progressive income taxation! For although it implies that the rich man should be taxed more than the poor man, it does not necessarily say that the former should be taxed more than proportionately. In fact, it does not even establish that all be taxed proportionately! In short, the equal-sacrifice principle may demand that a man earning $10,000 be taxed more than a man earning $1,000, but not necessarily that he be taxed a greater percentage or even proportionately. Depending on the shapes of the various “utility curves,” the equal-sacrifice principle may well call for regressive taxation under which a wealthier man would pay more in amount but less proportionately (e.g., the man earning $10,000 would pay $500, and the man earning $1,000 would pay $200). The more rapidly the utility of money declines, the more probably will the equal-sacrifice curve yield progressivity. A slowly declining utility-of-money schedule would call for regressive taxation. Argument about how rapidly various utility-of-money schedules decline is hopeless because, as we have seen, the entire theory is untenable. But the point is that even on its own grounds, the equal-sacrifice theory can justify neither progressive nor proportionate taxation.77

The minimum-sacrifice theory has often been confused with the equal-sacrifice theory. Both rest on the same set of false assumptions, but the minimum-sacrifice theory counsels very drastic progressive taxation. Suppose, for example, that there are two men in a community, Jones making $50,000, and Smith making $30,000. The principle of minimum social sacrifice, resting on the three assumptions described above, declares: $1.00 taken from Jones imposes less of a sacrifice than $1.00 taken from Smith; hence, if the government needs $1.00, it takes it from Jones. But suppose the government needs $2.00; the second dollar will impose less of a sacrifice on Jones than the first dollar taken from Smith, for Jones still has more money left than Smith and therefore sacrifices less. This continues as long as Jones has more money remaining than Smith. Should the government need $20,000 in taxes, the minimum-sacrifice principle counsels taking the entire $20,000 from Jones and zero from Smith. In other words, it advocates taking all of the highest incomes in turn until governmental needs are fulfilled.78

The minimum-sacrifice principle depends heavily, as does the equal-sacrifice theory, on the untenable view that everyone’s utility-of-money schedule is roughly identical. Both rest also on a further fallacy, which now must be refuted: that “sacrifice” is simply the obverse of the utility of money. For the subjective sacrifice in taxation may not be merely the opportunity cost forgone of the money paid; it may also be increased by moral outrage at the tax procedure. Thus, Jones may become so morally outraged at the above proceedings that his marginal subjective sacrifice quickly becomes very great, much “greater” than Smith’s if we grant for a moment that the two can be compared. Once we see that subjective sacrifice is not necessarily tied to the utility of money, we may extend the principle further. Consider, for example, a philosophical anarchist who opposes all taxation fervently. Suppose that his subjective sacrifice in the payment of any tax is so great as to be almost infinite. In that case, the minimum-sacrifice principle would have to exempt the anarchist from taxation, while the equal-sacrifice principle could tax him only an infinitesimal amount. Practically, then, the sacrifice principle would have to exempt the anarchist from taxation. Furthermore, how can the government determine the subjective sacrifice of the individual? By asking him? In that case, how many people would refrain from proclaiming the enormity of their sacrifice and thus escape payment completely?

Similarly, if two individuals subjectively enjoyed their identical money incomes differently, the minimum-sacrifice principle would require that the happier man be taxed less because he makes a greater sacrifice in enjoyment from an equal tax. Who will suggest heavier taxation on the unhappy or the ascetic? And who would then refrain from loudly proclaiming the enormous enjoyment he derives from his income?

It is curious that the minimum-sacrifice principle counsels the obverse of the ability-to-pay theory, which, particularly in its “state of well-being” variant, advocates a special tax on happiness and a lower tax on unhappiness. If the latter principle prevailed, people would rush to proclaim their unhappiness and deep-seated asceticism.

It is clear that the proponents of the ability-to-pay and sacrifice theories have completely failed to establish them as criteria of just taxation. These theories also commit a further grave error. For the sacrifice theory explicitly, and the ability-to-pay theory implicitly, set up presumed criteria for action in terms of sacrifice and burden.79 The State is assumed to be a burden on society, and the question becomes one of justly distributing this burden. But man is constantly striving to sacrifice as little as he can for the benefits he receives from his actions. Yet here is a theory that talks only in terms of sacrifice and burden, and calls for a certain distribution without demonstrating to the taxpayers that they are benefiting more than they are giving up. Since the theorists do not so demonstrate, they can make their appeal only in terms of sacrifice—a procedure that is praxeologically invalid. Since men always try to find net benefits in a course of action, it follows that a discussion in terms of sacrifice or burden cannot establish a rational criterion for human action. To be praxeologically valid, a criterion must demonstrate net benefit. It is true, of course, that the proponents of the sacrifice theory are far more realistic than the proponents of the benefit theory (which we shall discuss below), in considering the State a net burden on society rather than a net benefit; but this hardly demonstrates the justice of the sacrifice principle of taxation. Quite the contrary.

• 75The acceptance of this critique dates from Robbins’ writings of the mid-1930’s. See Lionel Robbins, “Interpersonal Comparisons of Utility,” Economic Journal, December, 1938, pp. 635–41; and Robbins, An Essay on the Nature and Significance of Economic Science (2nd ed.; London: Macmillan & Co., 1935), pp. 138–41. Robbins was, at that time, a decidedly “Misesian” economist.
• 76For a critique of sacrifice theory, see Blum and Kalven, Uneasy Case for Progressive Taxation, pp. 39–63.
• 77For an attempt to establish proportional taxation on the basis of equal sacrifice, see Bradford B. Smith, Liberty and Taxes (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, n.d.), pp. 10–12.
• 78Pushed to its logical conclusion in which the State is urged to establish “maximum social satisfaction”—the obverse of minimum social sac-rifice—the principle counsels absolute compulsory egalitarianism, with everyone above a certain standard taxed in order to subsidize everyone else to come up to that standard. The consequence, as we have seen, would be a return to the conditions of barbarism.
• 79The ability-to-pay principle is unclear on this point. Some proponents base their argument implicitly on sacrifice; others, on the necessity for payment for “untraceable” benefits.

The benefit principle differs radically from the two preceding criteria of taxation. For the sacrifice and ability-to-pay principles depart completely from the principles of action and the accepted criteria of justice on the market. On the market people act freely in those ways which they believe will confer net benefits upon them. The result of these actions is the monetary exchange system, with its inexorable tendency toward uniform pricing and the allocation of productive factors to satisfy the most urgent demands of all the consumers. Yet the criteria used in judging taxation differ completely from those which apply to all other actions on the market. Suddenly free choice and uniform pricing are forgotten, and the discussion is all in terms of sacrifice, burden, etc. If taxation is only a burden, it is no wonder that coercion must be exercised to maintain it. The benefit principle, on the other hand, is an attempt to establish taxation on a similar basis as market pricing; that is, the tax is to be levied in accordance with the benefit received by the individual. It is an attempt to achieve the goal of a neutral tax, one that would leave the economic system approximately as it is on the free market. It is an attempt to achieve praxeological soundness by establishing a criterion of payment on the basis of benefit rather than sacrifice.

The great gulf between the benefit and other principles was originally unrecognized, because of Adam Smith’s confusion between ability to pay and benefit. In the quotation cited above, Smith inferred that everyone benefits from the State in proportion to his income and that this income establishes his ability to pay. Therefore, a tax on his ability to pay will simply be a quid pro quo in exchange for benefits conferred by the State. Some writers have contended that people benefit from government in proportion to their income; others, that they benefit in increased proportion to their income, thus justifying a progressive income tax. Yet this entire application of the benefit theory is nonsensical. How do the rich reap a greater benefit proportionately, or even more than proportionately, from government than the poor? They could do so only if the government were responsible for these riches by a grant of special privilege, such as a subsidy, a monopoly grant, etc. Otherwise, how do the rich benefit? From “welfare” and other redistributive expenditures, which take from the rich and give to the bureaucrats and the poor? Certainly not. From police protection? But it is precisely the rich who could more afford to pay for their own protection and who therefore derive less benefit from it than the poor. The benefit theory holds that the rich benefit more from protection because their property is more valuable; but the cost of protection may have little relation to the value of the property. Since it costs less to police a bank vault containing $100 million than to guard 100 acres of land worth $10 per acre, the poor landowner receives a far greater benefit from the State’s protection than the rich owner of personalty. Neither would it be relevant to say that A earns more money than B because A receives a greater benefit from “society” and should therefore pay more in taxes. In the first place, everyone participates in society. The fact that A earns more than B means precisely that A’s services are individually worth more to his fellows. Therefore, since A and B benefit similarly from society’s existence, the reverse argument is far more accurate: that the differential between them is due to A’s individual superiority in productivity, and not at all to “society.” Secondly, society is not at all the State, and the State’s possible claim must be independently validated.

Hence, neither proportionate nor progressive income taxation can be sustained on benefit principles. In fact, the reverse is true. If everyone were to pay in accordance with benefit received, it is clear that (a) the recipients of “welfare” benefits would bear the full costs of these benefits: the poor would have to pay for their own doles (including, of course, the extra cost of paying the bureaucracy for making the transfers); (b) the buyers of any government service would be the only payers, so that government services could not be financed out of a general tax fund; and (c) for police protection, a rich man would pay less than a poor man, and less in absolute amounts. Furthermore, landowners would pay more than owners of intangible property, and the weak and infirm, who clearly benefit more from police protection than the strong, would have to pay higher taxes than the latter.

It becomes immediately clear why the benefit principle has been practically abandoned in recent years. For it is evident that if (a) welfare recipients and (b) receivers of other special privilege, such as monopoly grants, were to pay according to the benefit received, there would not be much point in either form of government expenditure. And if each were to pay an amount equal to the benefit he received rather than simply proportionately (and he would have to do so because there would be nowhere else for the State to turn for funds), then the recipient of the subsidy would not only earn nothing, but would have to pay the bureaucracy for the cost of handling and transfer. The establishment of the benefit principle would therefore result in a laissez-faire system, with government strictly limited to supplying defense service. And the taxation for this defense service would be levied more on the poor and the infirm than on the strong and the rich.

At first sight, the believer in the free market, the seeker after a neutral tax, is inclined to rejoice. It would seem that the benefit principle is the answer to his search. And this principle is indeed closer to market principles than the previous alleged canons. Yet, if we pursue the analysis more closely, it will be evident that the benefit principle is still far from market neutrality. On the market, people do not pay in accordance with individual benefit received; they pay a uniform price, one that just induces the marginal buyer to participate in the exchange. The more eager do not pay a higher price than the less eager; the chess addict and the indifferent player pay the same price for the same chess set, and the opera enthusiast and the novice pay the same price for the same ticket. The poor and the weak would be most eager for protection, but, in contrast to the benefit principle, they would not pay more on the market.

There are even graver defects in the benefit principle. For market exchanges (a) demonstrate benefit and (b) only establish the fact of benefit without measuring it. The only reason we know that A and B benefit from an exchange is that they voluntarily make the exchange. In this way, the market demonstrates benefit. But where taxes are levied, the payment is compulsory, and therefore benefit can never be demonstrated. As a matter of fact, the existence of coercion gives rise to the opposite presumption and implies that the tax is not a benefit, but a burden. If it really were a benefit, coercion would not be necessary.

Secondly, the benefit from exchange can never be measured or compared interpersonally. The “consumers’ surplus” derived from exchange is purely subjective, nonmeasurable, and non-comparable scientifically. Therefore, we never know what these benefits are, and hence there can be no way of allocating the taxes in accordance with them.

Thirdly, on the market everyone enjoys a net benefit from an exchange. A person’s benefit is not equal to his cost, but greater. Therefore, taxing away his alleged benefit would completely violate market principles.

Finally, if each person were taxed according to the benefit he receives from government, it is obvious that, since the bureaucracy receive all their income from this source, they would, like other recipients of subsidy and privilege, be obliged to return their whole salary to the government. The bureaucracy would have to serve without pay.

We have seen that the benefit principle would dispense with all subsidy expenditures of whatever type. Government services would have to be sold directly to buyers; but in that case, there would be no room for government ownership, for the characteristic of a government enterprise is that it is launched from tax funds. Police and judicial services are often declared by the proponents of the benefit principle to be inherently general and unspecialized, so that they would need to be purchased out of the common tax fund rather than by individual users. However, as we have seen, this assumption is incorrect; these services can be sold on the market like any others. Thus, even in the absence of all other deficiencies of the benefit principle, it would still establish no warrant for taxation at all, for all services could be sold on the market directly to beneficiaries.

It is evident that while the benefit principle attempts to meet the market criterion of limiting payment solely to beneficiaries, it must be adjudged a failure; it cannot serve as a criterion for a neutral tax or any other type of taxation.

Equality of taxation has far more to commend it than any of the above principles, none of which can be used as a canon of taxation. “Equality of taxation” means just that—a uniform tax on every member of the society. This is also called a head tax, capitation tax, or poll tax. (The latter term, however, is best used to describe a uniform tax on voting, which is what the poll tax has become in various American states.) Each person would pay the same tax annually to the government. The equal tax would be particularly appropriate in a democracy, with its emphasis on equality before the law, equal rights, and absence of discrimination and special privilege. It would embody the principle: “One vote, one tax.” It would appropriately apply only to the protection services of the government, for the government is committed to defending everyone equally. Therefore, it may seem just for each person to be taxed equally in return. The principle of equality would rule out, as would the benefit principle, all government actions except defense, for all other expenditures would set up a special privilege or subsidy of some kind. Finally, the equal tax would be far more nearly neutral than any of the other taxes considered, for it would attempt to establish an equal “price” for equal services rendered.

One school of thought challenges this contention and asserts that a proportional tax would be more nearly neutral than an equal tax. The proponents of this theory point out that an equal tax alters the market’s pattern of distribution of income. Thus, if A earns 1,000 gold ounces per year, B earns 200 ounces, and C earns 50 ounces, and each pays 10 ounces in taxes, then the relative proportion of net income remaining after taxes is altered, and altered in the direction of greater inequality. A proportionate tax of a fixed percentage on all three would leave the distribution of income constant and would therefore be neutral relative to the market.

This thesis misconceives the whole problem of neutrality in taxation. The object of the quest is not to leave the income distribution the same as if a tax had not been imposed. The object is to affect the income “distribution” and all other aspects of the economy in the same way as if the tax were really a free-market price. And this is a very different criterion. No market price leaves relative income “distribution” the same as before. If the market really behaved in this way, there would be no advantage in earning money, for people would have to pay proportionately higher prices for goods in accordance with the level of their earnings. The market tends toward uniformity of pricing and hence toward equal pricing for equal service. Equal taxation, therefore, would be far more nearly neutral and would constitute a closer approach to a market system.

The equal-tax criterion, however, has many grave defects, even as an approach toward a neutral tax. In the first place, the market criterion of equal price for equal service faces the problem: What is an “equal service”? The service of police protection is of far greater magnitude in an urban crime area than it is in some sleepy backwater. That service is worth far more in the crime center, and therefore the price paid will tend to be greater in a crime-ridden area than in a peaceful area. It is very likely that, in the purely free market, police and judicial services would be sold like insurance, with each member paying regular premiums in return for a call on the benefits of protection when needed. It is obvious that a more risky individual (such as one living in a crime area) would tend to pay a higher premium than individuals in another area. To be neutral, then, a tax would have to vary in accordance with costs and not be uniform.80 Equal taxation would distort the allocation of social resources in defense. The tax would be below the market price in the crime areas and above the market price in the peaceful areas, and there would therefore be a shortage of police protection in the dangerous areas and a surplus of protection in the others.

Another grave flaw of the equal-tax principle is the same that we noted in the more general principle of uniformity: no bureaucrat can pay taxes. An “equal tax” on a bureaucrat or politician is an impossibility, because he is one of the tax consumers rather than taxpayers. Even when all other subsidies are eliminated, the government employee remains a permanent obstacle in the path of equal tax. As we have seen, the bureaucrat’s “tax payment” is simply a meaningless bookkeeping device.

These flaws in the equal tax cause us to turn to the last remaining tax canon: the cost principle. The cost principle would apply as we have just discussed it, with the government setting the tax in accordance with costs, like the premiums charged by an insurance company.81 The cost principle would constitute the closest approach possible to neutrality of taxation. Yet even the cost principle has fatal flaws that finally eliminate it from consideration. In the first place, although the costs of nonspecific factors could be estimated from market knowledge, the costs of specific factors could not be determined by the State. The impossibility of calculating specific costs stems from the fact that products of tax-supported firms have no real market price, and so specific costs are unknown. As a result, the cost principle cannot be accurately put into effect. The cost principle is further vitiated by the fact that a compulsory monopoly—such as State protection—will invariably have higher costs and sell lower-quality service than freely competitive defense firms on the market. As a result, costs will be much higher than on the market, and, again, the cost principle offers no guide to a neutral tax.

A final flaw is common to both the equality and the cost theories of taxation. In neither case is benefit demonstrated as accruing to the taxpayer. Although the taxpayer is blithely assumed to be benefiting from the service just as he does on the market, we have seen that such an assumption cannot be made—that the use of coercion presumes quite the contrary for many taxpayers. The market requires a uniform price, or the exact covering of costs, only because the purchaser voluntarily buys the product in the expectation of being benefited. The State, on the other hand, would force people to pay the tax even if they were not voluntarily willing to pay the cost of this or any other defense system. Hence, the cost principle can never provide a route to the neutral tax.

• 80This does not concede that “costs” determine “prices.” The general array of final prices determines the general array of cost prices, but then the viability of firms is determined by whether the price people will pay for their products is enough to cover their costs, which are determined throughout the market. In equilibrium, costs and prices will all be equal. Since a tax is levied on general funds and therefore cannot be equivalent to market pricing, the only way to approximate market pricing is to set the tax according to costs, since costs at least reflect market pricing of the nonspecific factors.
• 81Blum and Kalven mention the cost principle but casually dismiss it as being practically identical with the benefit principle:
  Sometimes the theory is stated in terms of the cost of the government services performed for each citizen rather than in terms of the benefits received from such services. This refinement may avoid the need of measuring subjective benefits, but it does little else for the theory. (Uneasy Case for Progressive Taxation, p. 36 n)Yet their major criticism of the benefit principle is precisely that it requires the impossible measurement of subjective benefit. The cost principle, along with the benefit principle, dispenses with all government expenditures except laissez-faire ones, since each recipient would be required to pay the full cost of the service. With respect to the laissez-faire service of protection, however, the cost principle is clearly far superior to the benefit principle.

A slogan popular among many “right-wing” economists is that taxation should be for “revenue only,” and not for broad social purposes. On its face, this slogan is simply and palpably absurd, since all taxes are levied for revenue. What else can taxation be called but the appropriation of funds from private individuals by the State for its own purposes? Some writers therefore amend the slogan to say: Taxation should be limited to revenue essential for social services. But what are social services? To some people, every conceivable type of government expenditure appears as a “social service.” If the State takes from A and gives to B, C may applaud the act as a “social service” because he dislikes something about the former and likes something about the latter. If, on the other hand, “social service” is limited by the “unanimity rule” to apply only to those activities that serve some individuals without making others pay, then the “taxation-for-revenue-only” formula is simply an ambiguous term for the benefit or the cost principles.

We have thus analyzed all the alleged canons of tax justice. Our conclusions are twofold: (1) that economics cannot assume any principle of just taxation, and that no one has successfully established any such principles; and (2) that the neutral tax, which seems to many a valid ideal, turns out to be conceptually impossible to achieve. Economists must therefore abandon their futile quest for the just, or the neutral, tax.

Some may ask: Why does anyone search for a neutral tax? Why consider neutrality an ideal? The answer is that all services, all activities, can be provided in two ways only: by freedom or by coercion. The former is the way of the market; the latter, of the State. If all services were organized on the market, the result would be a purely free-market system; if all were organized by the State, the result would be socialism (see below). Therefore, all who are not full socialists must concede some area to market activity, and, once they do so, they must justify their departures from freedom on the basis of some principle or other. In a society where most activities are organized on the market, advocates of State activity must justify departures from what they themselves concede to the market sphere. Hence, the use of neutrality is a benchmark to answer the question: Why do you want the State to step in and alter market conditions in this case? If market prices are uniform, why should tax payments be otherwise?

But if neutral taxation is, at bottom, impossible, there are two logical courses left for advocates of the neutral tax: either abandon the goal of neutrality, or abandon taxation itself.