Taxation, as we have seen, takes from producers and gives to others. Any increase in taxation swells the resources, the incomes, and usually the numbers of those living off the producers, while diminishing the production base from which these others are drawing their sustenance. Clearly, this is eventually a self-defeating process: there is a limit beyond which the top-heavy burden can no longer be carried by the diminishing stock of producers. Narrower limits are also imposed by the disincentive effects of taxation. The greater the amount of taxes imposed on the producers—the taxpayers—the lower the marginal utility of work will be, for the returns from work are forcibly diminished, and the greater the marginal utility of leisure forgone. Not only that: the greater will be the incentive to shift from the ranks of the burdened taxpayers to the ranks of the tax-consumers, either as full-time bureaucrats or as those subsidized by the government. As a result, production will diminish even further, as people retreat to leisure or scramble harder to join the ranks of the privileged tax-consumers.34 In the market economy, net incomes are derived from wages, interest, ground rents, and profit; and in so far as taxes strike at the earnings from these sources, attempts to earn these incomes will diminish. The laborer, faced with a tax on his wages, has less incentive to work hard; the capitalist, confronting a tax on his interest or profit return, has more incentive to consume rather than to save and invest. The landlord, a tax being imposed on his rents, will have less of a spur to allocate land sites efficiently.

It has been objected that since a man’s marginal utility of money assets increases as he holds less of a stock of money, lower money income will mean an increased marginal utility of income. As a result, a tax on money incomes creates both a “substitution effect” against work and in favor of leisure (or against saving in favor of consumption) and an “income effect” working in the opposite direction. This is true, and in rare empirical cases, the latter effect will predominate. In plain language, this means that when extra penalties are placed upon man’s efforts he will generally slacken them; but in some cases, he will work harder to try to offset the burdens. In the latter cases, however, we must remember that he will lose the valuable consumption good of “leisure”; he will have less leisure now than he would have if his choices were still free. Working harder under penalty is only a cause for rejoicing if we regard the matter exclusively from the point of view of those living off the producers, who will thereby benefit from the tax. The standard of living of the workers, which must include leisure, has fallen.

The income tax, by taxing income from investments, cripples saving and investment, since it lowers the return from investing below what free-market time preferences would dictate. The lower net interest return leads people to bring their savings-investment into line with the new realities; in short, the marginal savings and investments at the higher return will now be valued below consumption and will no longer be made.

There is another, unheralded reason why an income tax will particularly penalize saving and investment as against consumption. It might be thought that since the income tax confiscates a certain portion of a man’s income and leaves him free to allocate the rest between consumption and investment, and since time preference schedules remain given, the proportion of consumption to saving will remain unchanged. But this ignores the fact that the taxpayer’s real income and the real value of his monetary assets have been lowered by paying the tax. We have seen in chapter 6 that, given a man’s time-preference schedule, the lower the level of his real monetary assets, the higher his time-preference rate will be, and therefore the higher the proportion of his consumption to investment. The taxpayer’s position may be seen in Figure 86, which is essentially the reverse of the individual time-market diagrams in chapter 6. In the present case, money assets are increasing as we go rightward on the horizontal axis, while in chapter 6 money assets were declining. Let us say that the taxpayer’s initial position is a money stock of 0M; tt is his given time-preference curve. His effective time-preference rate, determining his consumption/investment proportion, is t1. Now, suppose that the government levies an income tax, reducing his initial monetary assets at the start of his spending period to 0M′. His effective time-preference rate, the intersection of tt and the M′ line, is now higher at t2. He shifts to a higher proportion of consumption and a lower proportion of saving and investment.35

We have now seen two reasons why an income tax will shift the social proportion toward more consumption and less saving and investment. It might be objected that the time-preference reason is invalid, since the government officials and the people they subsidize will receive the tax revenues and find that their money stock has increased just as that of the taxpayers has declined. We shall see below, however, that no truly productive savings and investments can be made by government, its employees, or the recipients of its subsidies.

Some economists maintain that income taxation reduces savings and investment in society in yet a third way. They assert that income taxation, by its very nature, imposes a “double” tax on savings-investment as against consumption.36 The reasoning runs as follows: Saving and consumption are really not symmetrical. All saving is directed toward enjoying more consumption in the future; otherwise, there would be no point at all to 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. They are only the embodiment of increased consumption in the future. Saving-investment is Crusoe’s building the stick to obtain more apples at a future date; it fructifies in higher consumption later. Hence, the imposition of an income tax is a “double” tax on consumption, and excessively penalizes saving and investment.37

This line of reasoning correctly explains the investment-consumption process. It suffers, however, from a 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 preferences for present consumption. Every individual, given his current income and value scales, allocates that income in the most desirable proportions between consumption, investment, and additions to his cash balance. Any other allocation would satisfy his desires less well and lower his position on his value scale. The fructifying power of saving is already taken into account when he makes his allocation. There is therefore no reason to say that an income tax doubly penalizes saving-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 the other avenues of income allocation.

This Fisher argument reflects a curious tendency among economists devoted to the free market to be far more concerned about governmental measures penalizing saving and investment than they are about measures hobbling consumption. Surely an economist favoring the free market must grant that the market’s voluntary consumption/investment allocations are optimal and that any government interference in this proportion, from either direction, is distortive of that market and of production to meet the wants of the consumers. There is nothing, after all, particularly sacred about savings; they are simply the road to future consumption. But they are, then, clearly no more important than present consumption, the allocations between the two being determined by the time preferences of all individuals. The economist who balks more at interference with free-market savings than he does at infringement on free-market consumption is therefore implicitly advocating statist interference in the opposite direction. He is implicitly calling for a coerced distortion of resources to lower consumption and increase investment.38

• 34In the less developed countries, where a money economy is still emerging from barter, any given amount of taxation will have a still more drastic effect: for it will make monetary incomes much less worthwhile and will shift people’s efforts from trying to make money back to untaxed barter arrangements. Taxation can therefore decisively retard development from a barter to a monetary economy, or even reverse the process. See C. Lowell Harriss, “Public Finance” in Bernard F. Haley, ed., A Survey of Contemporary Economics (Homewood, Ill.: Richard D. Irwin, 1952), p. 264. For a practical application, see P.T. Bauer, “The Economic Development of Nigeria,” Journal of Political Economy, October, 1955, pp. 400 ff.
  If any government taxes in kind, there is then no span of time between taxation and the extraction of physical resources from the private sector. Both take place in the same act.
• 35For this shift to occur, the individual’s real monetary assets must decline, not just the nominal amount in terms of money. If, then, instead of this tax, there is deflation in the society, and the value of the monetary unit increases roughly proportionately everywhere, then the nominal fall in each individual’s money stock will not be a real fall, and hence effective time-preference ratios will remain unchanged. In the case of income taxation, deflation will not occur, since the government will spend the revenue rather than contract the money supply. (Even in the rare case where all the tax money is liquidated by the government, the individuals taxed will lose more than others and hence will lose some real monetary assets.)
• 36Thus, cf. 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.
• 37These economists generally conclude that not income, but only consumption, should be taxed as the only “real” income.
• 38The bias in favor of investment, or “growth,” as against present consumption, is similar to the conservationist attack on present consumption. What is so worthy about future consumption and so unworthy about consuming in the present? Perhaps what we have here is an illicit smuggling of the less rational aspects of the “Protestant ethic” into economic science. Of the many problems involved, we may mention one here: What nonarbitrary quantitative standards for thrift can the economist establish once the free market’s decision is overridden?

So far, we have discussed the impact of a tax on an individual considered by himself. Equally important is the distortion of the market’s pattern of factor prices and incomes, created by the way taxes bear down upon different people. The free market determines an intricate, almost infinite array and structure of prices, rates, and incomes. The imposition of different taxes disrupts these patterns and cripples the market’s work of allocating resources and output. Thus, if firm A pays $5,000 a year for a certain type of labor, and firm B pays $3,000, laborers will tend to shift from B to A and thereby more efficiently serve the wants of consumers. But if the income earned at firm A is taxed $2,000 per annum, while income at B is taxed negligibly or not at all, the market inducement to move from B to A will totally or virtually disappear, perpetuating a misallocation of productive resources and hampering the growth and even the existence of firm A.

We have seen above that the quest for a neutral tax—a tax neutral to the market, leaving the market roughly as it was before the tax was imposed—is a hopeless venture. For there can be no uniformity in paying taxes when some people in society are necessarily taxpayers, while others are privileged tax-consumers. But even if we disregard these objections and fail to consider the redistributionist effects of government spending out of tax revenues, we cannot arrive at a system of neutral taxation.39 Many writers have maintained that uniformly proportional income taxes for all would yield a neutral tax; for then, the relative ratios of incomes in society would remain the same as before. Thus, if A received $6,000 a year, B earned $3,000, and C $2,000, a 10-percent tax on each man would yield a “distribution” of: A, $5,400; B, $2,700; C, $1,800—the same mutual ratios as before. (This assumes, of course, no disincentive effects of the tax on the various individuals or, rather, equiproportional disincentive effects on each individual in the society—a most unlikely occurrence.) But the trouble is that this “solution” misconceives the nature of what a neutral tax would have to be. For a tax truly neutral to the free market would not be one that left income patterns the same as before; it would be a tax which would affect the income pattern, and all other aspects of the economy, in the same way as if the tax were really a free-market price.

This is a very important correction; for we must surely realize that when a service is sold at a certain price on the free market, this sale emphatically does not leave income “distribution” the same as before. For, normally, market prices are not proportional to each man’s income or wealth, but are uniform in the sense of equal to everyone, regardless of his income or wealth or even his eagerness for the product. A loaf of bread does not cost a multimillionaire a thousand times as much as it costs the average man. If, indeed, the market really behaved in this way, there would soon be no market, for there would be no advantage whatever in earning money. The more money one earned, the more, pari passu, the price of every good would be raised to him. Therefore, the entire civilized money economy and the system of production and division of labor based upon it would break down. Far from being “neutral” to the free market, then, a proportional income tax follows a principle which, if consistently applied, would eradicate the market economy and the entire monetary economy itself.

It is clear, then, that equal taxation of everyone—the so-called “head tax” or “poll tax”—would be a far closer approach to the goal of neutrality. But even here, there are serious flaws in its neutrality, entirely apart from the ineluctable taxpayer–tax-consumer dichotomy. For one thing, goods and services on the free market are purchased only by those freely willing to obtain them at the market price. Since a tax is a compulsory levy rather than a free purchase, it can never be assumed that each and every member of society would, in a free market, pay this equal sum to the government. In fact, the very compulsory nature of taxation implies that far less revenue would be paid in to the government were it conducted in a voluntary manner. Rather than being neutral, therefore, the equal tax would distort market results by imposing undue levies on at least three groups of citizens: the poor, the uninterested, and the hostile, i.e., those who, for one reason or another, would not have voluntarily paid these equal sums to the government.

Another grave problem in treating the equal tax as akin to a free-market price is that we do not know what “services” of government the people are supposed to be “purchasing.” For example, if the government uses the tax to subsidize a certain favored group, it is difficult to know what sort of “service” the payers of the head tax are reaping from this act of government. But let us take a seemingly clear-cut case of pure service, police protection, and let us assume that the head tax is being paid for this expenditure. The free-market rule is that equal prices are paid for equal services; but what, here, is an “equal service”? Surely, the service of police protection is of far greater magnitude in an urban crime center than it is in some sleepy backwater, where crime is rare. Police protection will certainly cost more in the crime-ridden area; hence, if it were supplied on the market, the price paid there would be higher than in the backwater. Furthermore, a person under particular threat of crime, and who might require greater surveillance, would have to pay a higher police fee. A uniform tax would be below market price in the dangerous areas and above it in the peaceful areas. To approach neutrality, then, a tax would have to vary in accordance with the costs of services and not be uniform.40 This is the neglected cost principle of taxation.

The cost principle, however, is hardly neutral either. Apart from the inexorable taxpayer–tax-consumer problem, there is, again, the problem of how a “service” is to be defined and isolated. What is the “service” of redistribution from Peter to Paul, and what is the “cost” for which Peter is to be assessed? And even if we confine the discussion to such common services as police protection, there are grave flaws. In the first place, the costs of government, as we shall see further below, are bound to be much higher than those of the free market. Secondly, the State cannot calculate well and therefore cannot gauge its costs accurately. Thirdly, costs are equal to prices only in equilibrium; since the economy is never in equilibrium, costs are never a precise estimate of what the free-market price would have been. And finally, as in the equal tax, and in contrast to the free market, the taxpayer never demonstrates his benefit from the governmental act; it is simply and blithely assumed that he would have purchased the service voluntarily at this price.

Still another attempt at neutral taxation is the benefit principle, which states that a tax should be levied equal to the benefit which the individuals receive from the government service. It is not always realized what this principle would mean: e.g., that recipients of welfare benefits would have to pay the full costs of these benefits. Each recipient of government welfare would then have to pay more than he received, for he would also have to pay the “handling” costs of government bureaucracy. Obviously, there would be no such welfare or any other subsidy payments if the benefit principle were maintained. Even if we again confine the discussion to services like police protection, grave flaws still remain. Let us again disregard the persistent taxpayer–tax-consumer dichotomy. A fatal problem is that we cannot measure benefits or even know whether they exist. As in the head tax and cost principles, there is here no free market where people can demonstrate that they are receiving a benefit from the exchange greater than the value of the goods they surrender. In fact, since taxes are levied by coercion, it is clear that people’s benefits from government are considerably less than the amount that they are required to pay, since, if left free, they would contribute less to government. The “benefit,” then, is simply assumed arbitrarily by government officials.

Furthermore, even if the benefit were freely demonstrable, the benefit principle would not approach the process of the free market. For, once again, individuals pay a uniform price for services on the free market, regardless of the extent of their subjective benefits. The man who would “walk a mile for a Camel” pays no more, ordinarily, than the man who couldn’t care less. To tax everyone in accordance with the benefit he receives, then, is diametrically opposed to the market principle. Finally, if everyone’s benefit is taxed away, there would be no reason for him to make the exchange or to receive the government service. On the market, not all people, not even the marginal buyers, pay the full amount of their benefit. The supramarginal buyers obtain unmeasurable surplus benefit, and so do the marginal buyers, for without such a surplus they would not buy the product. Moreover, for such services as police protection, the benefit principle would require the poor and the infirm to pay more than the rich and the able, since the former may be said to benefit more from protection. Finally, it should be noted that if each person’s benefit from government is to be taxed away, the bureaucrats, who receive all their income from the government, would have to return their whole salary to the government and so serve without pay.41

We have thus seen that no principle of taxation can be neutral with respect to the free market. Progressive taxation, where each man pays more than proportionately to his income, of course makes no attempt at neutrality. If the proportional tax embodies a principle destructive to the entire market economy and the monetary economy itself, then the progressive tax does so still more. For the progressive tax penalizes the able and efficient in even greater proportion than their relative ability and efficiency. Progressive rates are a particular disincentive against especially able work or entrepreneurship. And since such ability is engaged in serving the consumer, a progressive tax levies a particular burden on the consumers as well.

In addition to the two ways discussed above by which income taxation penalizes saving, the progressive tax imposes an added penalty. For empirically, in most cases, the wealthy save and invest proportionately more of their incomes than the lower-income groups. There is, however, no apodictic, praxeological reason why this must always be so. The rule would not hold, for example, in a country where the wealthy bought jewelry while the poor thriftily saved and invested.

While the progressive principle is certainly highly destructive of the market, most conservative, pro-free-market economists tend to overweigh its effects and to underweigh the destructive effects of proportional taxation. Proportional income taxation has many of the same consequences, and therefore the level of income taxation is generally more important for the market than the degree of progressivity. Thus, society A may have a proportional income tax requiring every man to pay 50 percent of his income; society B may have a very steeply progressive tax requiring a poor man to pay 1/4 percent and the richest man 10 percent of his income. The rich man will certainly prefer society B, even though the tax is progressive—demonstrating that it is not so much the progressivity as the height of his tax that burdens the rich man.

Incidentally, the poor producer, with a lower tax upon him, will also prefer society B. This demonstrates the fallacy in the common conservative complaint against progressive taxation that it is a means “for the poor to rob the rich.” For both the poor man and the rich man have, in our example, chosen progression! The reason is that the “poor” do not “rob the rich” under progressive taxation. Instead, it is the State that “robs” both through taxation, whether proportional or progressive.

It may be objected that the poor benefit from the State’s expenditures and subsidies from the tax proceeds and thus do their “robbing” indirectly. But this overlooks the fact that the State can spend its money in many different ways: it may consume the products of specific industries; it may subsidize some or all of the rich; it may subsidize some or all of the poor. The fact of progressivity does not in itself imply that the “poor” are being subsidized en masse. Indeed, if some of the poor are being subsidized, others will probably not be, and so these latter net taxpayers will be “robbed” along with the rich. In fact, since there are usually far more poor than rich, the poor en masse may very well bear the greatest burden of even a progressive tax system.

Of all the possible types of taxes, the one most calculated to cripple and destroy the workings of the market is the excess profits tax. For of all productive incomes, profits are a relatively small sum with enormous significance and impact; they are the motor, the driving force, of the entire market economy. Profit-and-loss signals are the prompters of the entrepreneurs and capitalists who direct and ever redirect the productive resources of society in the best possible ways and combinations to satisfy the changing desires of consumers under changing conditions. With the drive for profit crippled, profit and loss no longer serve as an effective incentive, or, therefore, as the means for economic calculation in the market economy.

It is curious that in wartime, precisely when it would seem most urgent to preserve an efficient productive system, the cry invariably goes up for “taking the profits out of war.” This zeal never seems to apply so harshly to the clearly war-borne “profits” of steel workers in higher wages—only to the profits of entrepreneurs. There is certainly no better way of crippling a war effort. In addition, the “excess” concept requires some sort of norm above which the profit can be taxed. This norm may either be a certain rate of profit, which involves the numerous difficulties of measuring profit and capital investment in every firm; or it may refer to profits at a base period before the war started. The latter, the general favorite because it specifically taps war profits, makes the economy even more chaotic. For it means that while the government strains for more war production, the excess profits tax creates every incentive toward lower and inefficient war production. In short, the EPT tends to freeze the process of production as of the peacetime base period. And the longer the war lasts, the more obsolete, the more inefficient and absurd, the base-period structure becomes.

• 39This is true if we also disregard the grave conceptual difficulties of arriving at a definition of “income,” in accounting for the imputed monetary value of work done within a household, of averaging fluctuating incomes over various years, etc.
• 40We are not here conceding 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 that people will pay for their particular products will be enough to cover the costs, which are determined throughout the market.
• 41Ever since Adam Smith, economists have tried, fallaciously, to use the benefit principle to justify proportional, and even progressive, taxation, on the ground that people benefit “from society” in proportion, or even more than in proportion, to their incomes. But it is clear that the rich benefit less from such services as police protection, since they could more afford to pay for their own than the poor. And the rich derive no benefit from welfare expenditures. Therefore, the rich derive fewer benefits, absolutely, from government than the poor, and the benefit principle cannot be used to justify proportional or progressive taxation.
       But, it might be objected, can’t we say that everyone derives proportional benefits to his income from “society,” though not from government? In the first place, this cannot be established. In fact, the opposite argument would be more accurate: for since both A and B participate in society and its benefits, any differential income between A and B must be due to their own particular worths rather than to society. Certainly equal benefits from society cannot be used to imply a proportional tax. And, furthermore, even if the argument were true, by what legerdemain can we say that “society” is equivalent to the State ? If A, B, C, producers on the market, benefit from each other’s existence as “society,” how can G, the government, use this fact to establish its claim to their wealth?

No discussion of taxation, however brief, can overlook the famous problem of “the shifting and incidence” of taxation. In brief, who pays a tax? The person on whom it is levied, or someone else to whom the former is able to “shift” the tax? There are still economists, incredibly, who hew to the old nineteenth-century “equal diffusion” theory of taxation, which simply closes the problem by proclaiming that “all taxes are shifted to everyone,” so that there is no need to analyze each one in particular.42 This obscurantist tendency is fostered by treating “shifting” in too broad a way. Thus, if an income tax is levied on Jones at 80 percent, this will hurt not only Jones, but also—by decreasing Jones’ incentives as well as capacities—other consumers by reducing Jones’ work and savings. It is therefore true that the effects of taxation diffuse outward from the center of the target. But this is far from saying that Jones can simply shift the tax burden onto the shoulders of others. The concept of “shifting” will here be limited to the case where the payment of a tax can be directly transferred from the original payer to someone else, and will not be used when others suffer in addition to the original taxpayer. The latter may be called the “indirect effects” of the tax.

The first rule of shifting is that an income tax cannot be shifted. This formerly accepted truth in economics is now countered with the popular assumption that, for example, a tax on wages will spur unions to demand higher wages to compensate for the tax, and that therefore the tax on wages is shifted “forward” onto the employer, who, in turn, shifts it again forward onto the body of consumers. And yet almost every step in this commonly proclaimed sequence is an egregious fallacy. It is absurd, in the first place, to think that workers or unions wait quietly for a tax to galvanize them into making demands. Workers always want higher wages; unions always demand more. The question is: Will they get more? There is no reason to think that they can. A worker can get only the value of the discounted marginal productivity of his labor. No clamor will raise that productivity, and therefore none can raise the wage he earns from his employer. Union demands for higher wages will be treated as usual, i.e., they can be satisfied only at the cost of the unemployment of some of the work force in that industry. But this is true whether or not there has been a tax on wages; the tax will have nothing to do with the final wage set on the market.

The idea that the increased cost will be passed on to the consumer by the employer is an illustration of perhaps the single most widespread fallacy on taxation: that businessmen can simply shift their higher costs forward onto the consumers in the form of higher prices. All the economic theory expounded in this book shows the error of this doctrine. For the price of a given product is set by the demand schedules of the consumers. There is nothing in higher costs or higher taxes which, per se, increases these schedules; hence, any change in selling prices, whether higher or lower, will decrease the revenues of the business involved. For each business, on the market, tends to be, at all times, at its “maximum profit point” in relation to the consumers. Prices are already at their point of maximum return for the business; therefore, higher taxes or other costs imposed on the firm will reduce their net incomes rather than be smoothly and easily passed on to consumers. We thus arrive at this significant conclusion: no tax (not just an income tax) can ever be shifted forward.

Suppose that a particularly heavy tax—of whatever type—has been laid on a specific industry: say the liquor industry. What will be the effects? As we have noted, the tax will not simply be “passed on” to the consumers.43 Instead, the price of liquor will remain the same; the net income of the firms will decline. This will mean that returns will be lower to capital and enterprise in liquor than in other industries of the economy; marginal liquor firms will suffer losses and go out of business; and, in general, productive resources of all types will flow out of liquor and into other industries. The long-run effect, therefore, is to decrease the supply of liquor produced, and therefore, by the law of supply and demand, to raise the price of liquor on the market. However, as we have said above, this process—this diffusion of suffering over the economy—is hardly “shifting.” For the tax is not simply “passed on”; it only permeates to the consumers through hurting the industry taxed. The final result will be a distortion of the factors of production; fewer goods are now being produced than the consumers would prefer in the liquor industry; and too many goods, relatively to liquor, are being produced in the other industry.

Taxes, in short, can more readily be “shifted backward” than forward. Strictly, the result is not shifting because it is not a painless process. But it is clear that the backward process (backward to the factors of production) happens more quickly and directly than the effects on consumers. For losses or lowered profits to liquor firms will immediately lower their demand for land, labor, and capital factors of production; this falling of demand schedules will lower wages and rents earned in the liquor industry; and these lower earnings will induce a shift of labor, land and capital out of liquor and into other industries. The rapid “backward-shifting” is in harmony with the “Austrian” theory of consumption and production developed in this volume; for prices of factors are determined by the selling prices of the goods which they produce, and not vice versa (which would have to be the conclusion of the naive “shifting-forward” doctrine).

It should be noted that, in some cases, the industry itself can welcome a tax upon it, for the sake of conferring an indirect, but effective, monopolistic privilege on the supramarginal firms. Thus, a flat “license” tax will confer a particular privilege on the more heavily capitalized firms, which can more easily afford to pay the fee.

• 42For a critique of this doctrine, see E.R.A. Seligman, The Shifting and Incidence of Taxation (New York: Macmillan & Co., 1899), pp. 122–36.
• 43Businessmen are particularly prone to this “passing on” argument—obviously in an attempt to convince consumers that they are really paying any tax on that industry. Yet the argument is clearly belied by the very zeal of each industry to have its taxes lowered and to fight against a tax increase. If taxes could really be shifted so easily and businessmen were simply unpaid collection agents for the government, they would never protest a tax on their industry. (Perhaps this is the reason why almost no businessmen have protested being collection agents for withholding taxes on their workers!)

The most popular example of a tax supposedly shifted forward is the general sales tax. Surely, for example, if the government imposes a uniform 20-percent tax on all retail sales, and if we can make the simplifying assumption that the tax can be equally well enforced everywhere, then business will simply “pass on” the 20-percent increase in all prices to consumers. In fact, however, there is no way for prices to increase at all! As in the case of one particular industry, prices were previously set, or approximately so, at the points of maximum net revenue for the firms. Stocks of goods or factors have not yet changed, and neither have demand schedules. How then could prices rise? Moreover, if we look at the general array of prices, as is proper when dealing with a general sales tax, these are determined by the supply of and the demand for money, from the goods and money sides. For the general array of prices to rise, there must be either an increase in the supply of money, a decrease in the demand schedule for money, or both. Nothing in a general sales tax causes a change in either of these determinants.44

Furthermore, the long-run effects of a general sales tax on prices will be smaller than in the case of an equivalent partial excise tax. A tax on a specific industry, such as liquor, will push resources out of this industry and into others, and therefore the relative price of the taxed commodity will eventually rise. In a general, uniformly enforced sales tax, however, there is no room for such shifts of resources.45

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 for consumers, thereby “causing inflation.” There is here no way that the general array of prices can rise, and the only possible result of such a wage increase is mass unemployment.46

In considering the general sales tax, many people are misled by the fact that the price paid by the consumer necessarily includes the tax. If someone goes to a movie and pays $1.00 admission, and if he sees prominently posted the information that this covers a “price” of 85¢ and a tax of 15¢, he tends to conclude that the tax has simply been added on to the “price.” But $1.00 is the price, not 85¢, the latter sum simply being the revenue accruing to the firm after taxes. The revenue to the firm has, in effect, been reduced to allow for payment of taxes.

This is precisely the consequence 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, the loss in gross revenue of firms being imputed backward to interest income by capitalists and to wages and rents earned by owners of original factors—labor and ground land. A decrease in gross revenue to retail firms is reflected back to a decreased demand for the products of all the higher-order firms. The major result of a general sales tax is a general reduction in the net revenues accruing to original factors. The sales tax has been shifted backwards to original factor returns—to interest and to all wages and ground rents. No longer does every original factor of production earn its discounted marginal product. Original factors now earn less than their DMVPs, the reduction consisting of the sales tax paid to the government.

Let us now 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. Whether or not the government spends the money for resources for its own activities or simply transfers the money to people it subsidizes, the effect 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. 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 of those subsidized by the government has been increased at the expense of the tax producers, and therefore consumption and investment demands on the market have been shifted from the producers to the expropriators by the amount of the tax. As a consequence, the value of the monetary 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 and a rise in the price of arms, and a tendency for nonspecific factors to shift out of the production of clothing and into the production of armaments.

As a result, there will not finally be, as might be assumed, a proportional 20-percent fall in all original factor incomes as the result of a 20-percent general sales tax. Specific factors in industries that have lost business from the shift from private to governmental demand will lose proportionately more in income; specific factors in industries gaining in demand will lose proportionately less—some may gain so much as to gain absolutely from 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.

It should be carefully noted that the general sales tax is a conspicuous example of failure to tax consumption. The sales tax is commonly supposed to penalize consumption, rather than income or capital. Yet we find that the sales tax reduces, not just consumption, but the incomes of original factors. The general sales tax is therefore an income tax, albeit a rather haphazard one. Many “right-wing” economists have advocated general sales taxation, as opposed to income taxation, on the grounds 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 a 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 saving-investment of the taxpayers.47 In fact, since, as we have seen, 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 fall more heavily on savings-investment than on consumption in its ultimate incidence.

• 44It might be objected that the firms can pass along the sales tax because it is a general increase for all firms. Aside from the fact that no relevant general factor (supply, demand for money) has increased, the individual firm is still concerned only with its individual demand curve, and these curves have not shifted. A tax increase has done nothing to make a higher price more profitable than it was before.
• 45Resources can now shift only from work into idleness (or into barter). This, of course, may and probably will happen; since, as we shall see further, a sales tax is a tax on incomes, the rise in opportunity cost of leisure may push some workers into idleness and thereby lower the quantity of goods produced. To this extent, prices will eventually rise, although hardly in the smooth, immediate, proportionate way of “shifting.” See the pioneering article by Harry Gunnison Brown, “The Incidence of a General Output or 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. While this was the first modern attack on the fallacy that sales taxes are shifted forward, Brown unfortunately weakened the implications of this thesis toward the end of his article.
• 46Of course, if the money supply is increased after a wage rise, and credit expanded, prices can be raised so that money wages are again not above their discounted marginal value products.
• 47Mr. 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 is clear from our discussion that there are few taxes indeed that will not be as bad as the income tax from the viewpoint of the free market. Certainly sales or excise taxation will not fill the bill.
       Mr. 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 right, and there is nothing in an “indirect tax” which makes the 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, since here the directness covers only retail storekeepers instead of the bulk of the population.

Wherever taxes fall, they blight, hamper, and distort the productive activity of the market. Clearly, a tax on wages will distort the allocation of labor effort, a tax on profits will cripple the profit-and-loss motor of the economy, a tax on interest will tend to consume capital, etc. One commonly conceded exception to this rule is the doctrine of Henry George that ground-landowners perform no productive function and that therefore the government may safely tax site value without reducing the supply of productive services on the market. This is the economic, as distinguished from the moral, rationale for the famous “single tax.” Unhappily, very few economists have challenged this basic assumption, the single-tax proposal being generally rejected on grounds purely pragmatic (“there is no way in practice of distinguishing site from improvement value of land”) or conservative (“too much has been invested in land to expropriate the landowners now”).48

Yet this central Georgist contention is completely fallacious. The owner of ground land performs a very important productive service. He finds, brings into use, and then allocates, land sites to the most value-productive bidders. We must not be misled by the fact that the physical stock of land is fixed at any given time. In the case of land, as of other material goods, it is not just the physical good that is being sold, but a whole bundle of services along with it—among which is the service of transferring ownership from seller to buyer, and doing so efficiently. Ground land does not simply exist; it must be served to the user by the owner (one man, of course, can perform both functions when the land is “vertically integrated”).49 The landowner earns the highest ground rents by allocating land sites to their most value-productive uses, i.e., to those uses most desired by consumers. In particular, we must not overlook the importance of location and the productive service of the site-owner in assuring the most productive locations for each particular use.

The view that bringing sites into use and deciding upon their location is not really “productive” is a vestige from the old classical view that a service which does not tangibly “create” something physical is not “really” productive.50 Actually, this function is just as productive as any other, and a particularly vital function it is. To hamper and destroy this function would wreck the market economy.51

• 48Thus, even so eminent an economist as F.A. Hayek has recently written:
  This scheme [the single tax] for the socialization of land is, in its logic, probably the most seductive and plausible of all socialist schemes. If the factual assumptions on which it is based were correct, i.e., if it were possible to distinguish clearly between the value of the “permanent and indestructible powers” of the soil ... and ... the value due to ... improvement ... the argument for its adoption would be very strong. (F.A. Hayek, The Constitution of Liberty , pp. 352–53) Also see a somewhat similar concession by the Austrian economist von Wieser. Friedrich Freiherr von Wieser, “The Theory of Urban Ground Rent” in Louise Sommer, ed., Essays in European Economic Thought (Princeton, N.J.: D. Van Nostrand, 1960), pp. 78 ff.
• 49I do not know anyone who has brought out the productivity of landowners as clearly as Mr. Spencer Heath, an ex-Georgist. See Spencer Heath, How Come That We Finance World Communism? (mimeographed MS., New York: Science of Society Foundation, 1953); idem, Rejoinder to ‘Vituperation Well Answered’ by Mr. Mason Gaffney (New York: Science of Society Foundation, 1953); idem, Progress and Poverty Reviewed (New York: The Freeman, 1952).
• 50Spencer Heath comments on Henry George as follows:
  Wherever the services of land owners are concerned he is firm in his dictum that all values are physical. ... In the exchange services performed by [landowners], their social distribution of sites and resources, no physical production is involved; hence he is unable to see that they are entitled to any share in the distribution of physical things and that the rent they receive ... is but recompense for their non-coercive distributive or exchange services. ... He rules out all creation of values by the services performed in [land] distribution by free contract and exchange, which is the sole alternative to either a violent and disorderly or an arbitrary and tyrannical distribution of land. (Heath, Progress and Poverty Reviewed, pp. 9–10)
• 51For the effects of the “single tax” and for other criticisms, see Murray N. Rothbard, The Single Tax: Economic and Moral Implications (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1957); Rothbard, “A Reply to Georgist Criticisms” (mimeographed MS., Foundation for Economic Education, 1957); and Frank H. Knight, “The Fallacies in the ‘Single Tax,’” The Freeman, August 10, 1953, pp. 810–11. One of the more amusing objections is that of the dean of Georgist economists, Dr. Harry Gunnison Brown. Although the Georgists base much of their economic case on a sharp distinction between ownership of land and ownership of improvements on that land, Brown tries to refute the disruptive economic effects of the single tax by implicitly assuming that land and improvements are owned by the same people anyway! Actually, of course, the disruptive effects remain; vertical integration by individuals or firms does not remove the economic principle from either of the integrated stages of production. See Harry Gunnison Brown, “Foundations, Professors and ‘Economic Education,’” The American Journal of Economics and Sociology, January, 1958, pp. 150–52.

In this necessarily hasty overview of the high spots of taxation theory, we have space for only one more comment: a criticism of the very common view that, in a business boom, the government should increase taxation “in order to sop up excess purchasing power,” and thereby halt the inflation and stabilize the economy. We shall discuss the problems of inflation, stabilization, and the business cycle below; here, let us note the oddity of assuming that a tax is somehow less of a social cost, less of a burden, than a price. Thus, suppose, in a boom, that Messrs. A, B, and C, with the money they have on hand, would spend a certain amount on some commodity—say pipes—at a certain market price, e.g., $10 per pipe. The government decides that this is a most unfortunate situation, that the market price is—by some arbitrary, undivulged standard—”too high,” and that therefore it must help its subjects by taxing their money away from them, and thus lowering prices. Suppose, indeed, that A, B, and C are taxed sufficiently to lower the pipe price to, say, $8. By what reasoning are they better off, now that taxes have been increased by precisely the amount that their monetary funds have dwindled? In short, the “tax price” has gone up in order that the prices of other goods may decline. Why is a voluntary price, paid willingly by buyers and accepted by sellers, somehow “bad” or burdensome for the buyers, while at the same time a “price” levied compulsorily on the same buyers for dubious governmental services for which they have not demonstrated a need is somehow “good”? Why are high prices burdensome and high taxes not?