Adam Smith, The Adam Smith Institute and Flat Tax
Abstract: The Adam Smith Institute is in favour of moving UK income tax to a flat-tax regime. Yet there are strong reasons to doubt whether a flat-tax regime would have been endorsed by Adam Smith himself, whose views on the distribution of the tax burden appear more progressive than a flat tax on incomes allows for. However by employing Smith’s name, the Adam Smith Institute implies that the founder of modern economics advocated their tax policies, thereby providing them with an authoritative intellectual legitimacy they may not in fact posses.
I
The right of centre think-tank The Adam Smith Institute (ASI) is in favour of a flat-tax regime for UK income tax. The ASI’s report, A flat tax for the UK – A Practical Reality (PDF), states: “the fundamental principle [of a flat tax] is that income should be taxed at a single rate of tax for all taxpayers.” Flat tax is thus an example of what is known as a “proportionate” tax.
The consequences of such a tax are as follows: if Albert earns £1million, and Bradley earns £15,000, and they both incur a flat-rate of (say) 20% income tax. Albert will pay £200,000 in tax and be left with £800,000, whereas Bradley will pay the lower absolute sum of £3000 in tax, but leaving him with £12,000. The rate of tax incurred stays the same at all income levels: whilst the absolute sum contributed by each taxpayer rises with income, the rate of tax incurred stays the same.
Given that Albert’s income in our example is so much greater than Bradleys, it may be objected that it is unfair for both to pay the same rate. This, it might be said, is because Albert could contribute at a higher rate to the society which is itself a pre-requisite for him being able to become (or stay) rich in the first place. Furthermore, Albert could make that greater contribution whilst still remaining considerably better-off than Bradley. Thus opponents of flat taxes will tend to argue that it is fair for better-off Albert to pay a higher rate of tax on some of his earnings than what worse-off Albert pays on all of his. Opponents of flat taxes therefore typically promote what are termed “progressive” taxation systems, under which the rate of tax increases as income increases, usually be establishing higher “bands” of taxation above certain income thresholds.
The standard reply of flat tax proponents to the charge of unfairness is to advocate a personal allowance for all earners, which is not taxed. For example, the ASI report suggests a tax-free personal allowance of £12,000 (almost twice that of the existing UK tax-free allowance). Proponents of flat tax thus argue that it doesn’t hurt the poorest, and by implication isn’t unfair in that respect: the poorest just wouldn’t pay income tax. Above the threshold level, however, everyone incurs the same headline rate, which the ASI believes is a fair way to distribute the tax burden. (It should however be noted that, as a consequence of this tax-free threshold, effective or marginal rates of tax do vary with income levels – even though the headline rate doesn’t – in a way they did not in our above example of a flat tax with no allowance. More will be said on this later).
So, under the ASI’s proposals, whether a person earns £20,000 or £10 billion a year, they would only incur a 22% headline rate of income tax, minus the initial tax-free allowance. This will still be found objectionable by proponents of progressive taxation, who believe that the rate of tax incurred should increase above certain income thresholds reflecting higher earner’s increased ability to pay, regardless of the presence of an enlarged tax-free allowance benefiting the poorest. Those, in essence, are the dividing lines (though more will need to be said about them in due course).
The aim of this paper is not to assess the merits or otherwise of a flat tax regime for UK income tax. Whilst the Tax Justice Network is certainly not in favour of flat tax regimes, the arguments as to why flat tax is undesirable have been articulated elsewhere (PDF). The purpose here is to explore the question of whether Adam Smith himself would have supported the ASI’s promotion of a flat tax regime. There are strong reasons to suspect he would not.
II
Adam Smith’s discussion of taxation takes place in Volume II, Book V of An Enquiry in the Nature and Causes of the Wealth of Nations. It would be easy to selectively cherry-pick quotations from this section and accuse the ASI of advocating policies at odds with Smith’s views. Yet it would also be somewhat disingenuous. Smith’s discussion of taxation is wide-ranging and complex. He does not set out to offer specifically normative recommendations, but instead provides an analysis laced with historical comparisons and periodic injections of value judgement. Thus to avoid the charge of selective representation, we must take some time to consider Smith’s views on taxation.
Smith thought that taxes were most certainly necessary. He considered “public stock and lands” as sources of state revenue, and declared them to be “insufficient funds for defraying the necessary expence of any great and civilised state.”[i] What was required to make up the shortfall was taxation.
Smith understood tax as being levied in five broad categories. Firstly, there could be direct taxation on the following three things: rent (including land and houses), profits arising from investments (“stock”), and wages. Additionally, there could be a general “capitation” tax levied on all individuals, which they would be expected to pay out of the first three categories as they saw fit or were able. Finally, there were “taxes on consumable Commodities”, or what we would now recognise as indirect taxes on the transactions of goods and services, for example VAT or sales tax.
An initial obstacle should therefore be noted: Smith did not discuss taxes on income in the modern sense. This is simply because income tax did not exist in its modern form when Smith was writing. Therefore to come to a conclusion as to whether Smith would have supported a flat-tax on incomes requires exploring his thought in other areas of taxation and inferring what his position on flat rate income tax would likely have been. Thankfully this is quite possible.
I will here focus on Smith’s discussion of taxes on wages and on rent. This is because I do not find his discussion of the other categories pertinent to the issue of inferring Smith’s likely views on flat-rate taxation. (I have written briefly elsewhere about some of Smith’s views on indirect taxes. As regards “capitation” taxes, Smith’s discussion appears especially irrelevant to modern debates due to contextual factors, and anyway Smith broadly thought such taxes to be unsuccessful and counterproductive. As regards taxes on “stock”, in the interests of intellectual integrity we should acknowledge here that Smith would certainly not have seen eye-to-eye with the Tax Justice Network. He is clear that he believes taxing profits from investment will cause investors to flee to other jurisdictions, and thus such taxes are pointless and should not be undertaken. On this point, Smith is certainly far closer to the ASI than the TJN).
Before turning to consider taxes on wages and rent, however, we must note Smith’s “four maxims” of tax: equality, certainty, convenience of payment and economy in collection. Smith believed these maxims were conditions that needed to be fulfilled as fully as possible for any tax regime to be worthwhile and desirable. It should be noted that these maxims are now outmoded and anachronistic, and a satisfactory modern tax system must go considerably beyond these conditions (PDF). Nonetheless, examining Smith’s maxims is important if we are to infer what his likely position on modern tax debates would have been, even if aspects of his thought are now practically outmoded.
Of equality, Smith says the following:
“The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the protection of the state. The expence of government to the individuals of a great nation, is like the expence of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. In the observation or neglect of this maxim consists, what is called the equality or inequality of taxation.”[ii]
At first-glance this passage appears to be a clear statement of a preference for progressive taxation and a rejection of the principles underlying flat tax regimes: people ought to contribute “in proportion to their respective abilities”. Yet a flat-tax regime does not increase the rate of tax upon those earning higher incomes, despite their increased ability to pay higher rates of taxation: everyone incurs the same rate minus an initial allowance. So would Adam Smith be against the flat tax?
We cannot conclude so quickly. Proponents of flat tax at the ASI could plausibly claim that Smith’s words are consistent with their policy, by arguing that because somebody on a higher income pays more tax in absolute terms (whilst incurring the same rate minus an initial allowance), that means that they are in fact paying in proportion to their respective abilities, and this is achieved by a flat rate tax. So to decide if Adam Smith would have opposed a flat tax regime we need to go considerably further than this one quote.
Having said that, we should let the sword of reason cut both ways and head-off a reply from the ASI that flat-tax would have been preferred by Smith on the grounds of being conducive to “certainty”. Smith’s second maxim – that “the time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and every other person” – was considered of great importance by Smith:
“The certainty of what each individual ought to pay is, in taxation, a matter of so great importance, that a very considerable degree of inequality, it appears, I believe, from the experience of all nations, is not near so great an evil as a very small degree of uncertainty”[iii]
The ASI advocates flat tax in part because it is “simple”. They claim that because everyone knows what they pay and that amount is easily calculable, the compliance costs of paying are low and so the tax yield is high. Flat taxes are certain, for sure, and in the sense that Smith advocated. Yet it is clear that the flat-taxers have no monopoly on certainty, which is not the same thing as “simplicity”. There is nothing “uncertain” about an income tax regime that has progressive gradations of tax rates relative to income, especially in the UK where most income is taxed at source. A modern state can administer such a regime with as equal a degree of certainty as a flat tax regime. Smith’s prioritising of certainty over equality does not provide evidence of a support for flat taxes.
Similar things must be said of the other maxims, “convenience of payment” and “economy in collection”. The ASI promotes the flat tax in part because they claim its simplicity will lead to lower compliance costs and a higher tax yield. Can Smith’s insistence on “convenience of payment” be taken as evidence of his preference for a flat tax? Again, the answer is no: in terms of modern tax collection systems, there is no difference in “convenience of payment” (i.e. how one goes about paying-up to the state) between a flat-rate or a progressive taxation system. Whether the rate is 20% or 40%, the convenience of payment is the same (though the willingness may indeed by different, as the ASI is apt to point out).
As regards “economy in collection” (the efficiency of administering and collecting a tax), proponents of flat tax typically claim that their regime will prove more efficient to administer. This is because of e.g. the alleged virtues of simplification, the lowering of incentives to avoid and evade tax, and a claimed correlate reduction in the number of state employees needed to administer and collect tax. If this is indeed the case, then it might lend some support to the idea that Smith would have favoured a flat tax regime. This is, however, an empirical question, and insofar as the ASI is right or wrong about the answer to the question of increased efficiency, the claim to be representing Smith’s views by advocating flat tax stands or falls.
More importantly, “economy of collection” was not the defining factor for Smith in terms of what made a good tax regime. Even if a flat tax regime produces greater “economy in collection” than a progressive regime, it does not follow that Smith would therefore automatically have preferred the former. It is entirely reasonable to suppose that Smith would have tolerated a larger degree of diseconomy in collection in a progressive tax regime compared with a flat-tax regime, if the former yielded benefits or exhibited features that Smith held to be especially important. Indeed there is evidence that this was the case, as we shall see. It should also be noted that in his discussion[iv] of taxes on land rent, Smith states that although it is more expensive to tax on a basis of varying rather than fixed land-values, he believes this is a price worth paying for a better over-all tax regime. Economy in collection was clearly not the necessarily decisive factor for Smith.
III
Those preliminary matters established, we can now delve into Smith’s discussions of specific taxes to assess whether or not he would have backed a flat tax on income. As stated above, I shall focus only upon taxes upon wages and rent, as these are the most pertinent areas of Smith’s discussion for our purposes.
Having said that Smith’s discussion of “taxes upon the Wages of Labour” will not provide us with any answers (although it is important to consider his discussion nonetheless). This is because Smith thought that there should be no taxes on wages of labour at all.
His reasoning was simple: “While the demand for labour and the price of provisions, therefore, remain the same, a direct tax upon the wages of labour can have no other effect than to raise them somewhat higher than the tax”[v]. And Smith thought this would be terrible: the result would be effective higher wages, which would lead to economic stagnation. He laments, however, that “Absurd and destructive as such taxes are…they take place in many countries”[vi] (before going on to criticise the French, as he is apt to do at regular intervals).
Smith’s conviction that wages should not be taxed does not, however, translate into support for a flat rate of income tax. Just because Smith thought it was a bad idea to tax wages does not mean that, given the context of established income-tax regimes in the modern world, he would therefore have been in favour of everyone paying the same rate (albeit with an initial tax-free allowance). We simply cannot say, one way or the other, and that fact must be openly acknowledged.
By contrast, if we turn to what Smith says about taxes on the rent of land and houses, there is evidence that he was in fact strongly inclined towards proportionately increasing the tax burden on the better off.
Smith’s discussion of taxes on rent is long and detailed. It incorporates two broad aspects: taxes on land and taxes upon houses. Both are revealing insofar as they appear to demonstrate a clear preference from Smith in favour of progressive taxation over a flat tax regime.
We begin with taxes on land. Smith thought that taxing the “rent” from land had great potential as a source of revenue for the state. Considering land rent taxes assessed on a fixed valuation, Smith wrote that such a tax was “perfectly agreeable” to the three maxims of certainty, economy of collection and convenience of payment: “it subjects the landlord to no other inconveniency besides the unavoidable one of paying the tax”[vii]. However, Smith felt that such a tax “offends against the first of the four maxims”, equality.[viii] Accordingly, he advocated a system of taxing land rents based on variable valuations of land to eliminate that problem, thus making taxes on land rent a most desirable sort of tax.
Smith’s advocacy of a land rent tax is instructive. Although in this section he does not pass normative judgement about who should shoulder the tax burden, there is an obvious implication in Smith’s opinion that taxes on land rent are good and desirable. Then (as now) landownership was concentrated in the hands of a wealthy minority: if land rent taxes are a good and proper source of taxation, and wages on labour are not, the implication is clear that Smith thought it proper for the better-off to shoulder the tax burden. Now this, of course, does not translate into a concrete opposition to a flat tax regime. It merely indicates that Smith may have been in favour of the better-off shouldering the tax burden. For solid indications that Smith would not have backed a flat tax regime, we turn to rent on houses.
Smith was in favour of taxing the rent on houses: “Ground rents [on houses] and the ordinary rent of land, are, therefore, perhaps, the species of revenue which can best bear to have a peculiar tax imposed upon them.”[ix] Although Smith believed that taxing the rent on houses is really a tax on land-profit and wages (because houses don’t produce anything themselves), he goes on to say that “nothing can be more reasonable than that a fund which owes its existence to the good government of the state, should be taxed peculiarly, or should contribute something more than the greater part of other funds, towards the support of government.[x]”
It is the rich who, in seeking the biggest and most expensive houses, will typically incur the greatest taxes in house rent, and Smith thinks this is just fine. (Indeed, he apparently believes that taxes on house rent will encourage people to rent smaller houses and divert their spending into more productive channels than simply paying rent on a big house, thus benefitting the wider economy[xi].)
It is in his discussion of house rents, however, that Smith voices sentiments towards taxation that appear highly progressive in nature, indicating a preference for the better-off shouldering an increasing burden of tax:
“The inequality with which a tax of this kind might fall upon the owners of different ground-rents, would arise altogether from the accidental inequality in this division. But the inequality with which it might fall upon the inhabitants of different houses would arise, not only from this, but from another cause. The necessaries of life occasion the great expence of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principle expence of the rich; and a magnificent house embellishes and sets off to the best advantages and the other luxuries and vanities which they possess. A tax upon house-rents, therefore, would in general fall heaviest upon the rich”[xii]
“The principal objection to all such taxes [window taxes] is their inequality, and inequality of the worst kind, as they must frequently fall much heavier upon the poor than upon the rich. A house of ten pounds rent in a country town may sometimes have more windows than a house of five hundred pounds rent in London; and though the inhabitant of the former is likely to be a much poorer man than that of the latter.”[xiii]
Are such sentiments that the rich should incur greater tax proof that Smith would have opposed a flat tax regime? We cannot conclude this yet, for two reasons.
First we must acknowledge a lurking problem I have so far deliberately ignored: that proponents of flat tax systems are fond of arguing that their preferred regime is in fact “more progressive” than what is traditionally termed a progressive regime. This generally relies upon the argument that a larger tax-free allowance than under (traditional) progressive systems, plus a flat rate tax, results in more progressive distribution of the tax burden because of the affect of a large tax-free allowance upon the effective or marginal rate of tax paid.
There are reasons to doubt the flat-taxer’s contention that their system is “more” progressive than an income tax regime with higher rates for higher earners above certain thresholds. For example, with the ASI’s scenario of a 22% flat tax and a threshold of £12,000, a person on £15,000 would pay £660 in tax, which is an effective tax rate of 4.4%. A person earning £100,000 would pay £19,360 in tax which is an effective rate of 19.3%. But it is important to note that this isn’t the end of the matter, because the effective rate converges asymptotically on a final flat rate. Someone earning £200,000 would pay £41,360 which is an effective rate of 20.68%. As income increases upwards towards the millions and billions, the effective rate of tax paid gets ever closer to 22% (though because of the mathematical limit, cannot ever reach it).
The result is as follows. At the lower ends of the income scale, because of the tax free allowance, a considerable progressivity of effective tax results: compare the 4.4% rate with the 19.3% rate in our example above. Yet as income increases the progressivity of a flat tax decreases because the effective marginal tax approaches the mathematical limit of 22%. This means that above the mark of around £60,000, the flat tax begins to lose meaningful progressivity, because earnings over that sum bunch ever closer to the 22% mark. This means that the richest see only tiny increases in the effective marginal tax rate incurred. This would not be the case if, as under a progressive tax system, they incurred a higher rate of (say) 40% on income over a certain threshold. Thus there are strong reasons to doubt that flat tax is “more progressive” than progressive taxation.
However, to the extent that proponents of the flat tax continue to claim that it is more progressive than progressive taxation (as that term is usually understood), it is no use citing passages of Smith where that author exhibits a merely progressive sentiment. The flat-taxers will claim that as evidence that Smith supported a flat tax.
The second objection is that Smith writes the following: “A proportional tax upon this particular article of expence [house rent] might, perhaps, produce a more considerable revenue than any which has hitherto been drawn from it in any part of Europe.”[xiv] And this, it might be argued, is evidence that Smith supported proportional – i.e. flat – taxes.
Are these objections decisive? The answer is no, for the following reasons.
To take the second objection first, it is clear that Smith is simply observing that a proportional tax on house rents would likely produce a “considerable revenue”, and more so than other established systems of tax at his time. It is not a declaration that taxes should only be proportionate. There is nothing to suggest Smith would rule out a further, compatible thought: house rents should rise in proportion as the article of expense increases.
Indeed, there is in fact evidence that he thought precisely this. And it is, conveniently, the same evidence which indicates that Smith was in favour of progressive taxation as traditionally understood rather than in revisionist senses promoted by flat tax advocates by focusing on marginal rates at the lower end of the income scale. For Smith writes:
“A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be any thing very unreasonable. It is not very unreasonable that the rich should contribute to the public expence, not only in proportion to their revenue, but something more than in proportion.”[xv] (emphasis mine)
Two things are important to note here: firstly, this sentiment is apparently being applied not just to house rents, but to contributions to the “public expence” generally. It can thus fairly be applied to other areas of taxation, and used to infer what Smith would have thought about taxes more widely than just those concerning house rents. Secondly, and crucially, it is a clear statement that the rich ought to contribute “something more than in proportion” to their revenue; a statement that could be equally well expressed by saying that the rich should incur higher rates of taxation.
Of course, the issue is not settled decisively. The ASI could claim that when Smith states that the rich should pay “something more than in proportion”, a system whereby rising incomes were taxed at a limit approaching 22% (bunching ever closer to that figure), would have satisfied him. Here we must exercise our discretion. Do we think this is in fact the case, or do we believe it more likely that Smith would have favoured a progressive tax system whereby higher earners do not just incur marginal tax rates increasing towards 22%, but rather incur higher headline rates of tax over certain income thresholds? I would suggest that, given the tenor of the above remarks, and the tendency of a flat rate tax to increase the marginal rate of tax by only very tiny amounts for ever higher incomes, it is more plausible that Smith would have favoured progressive taxation than a flat tax.
IV
I do not present this analysis as conclusive, and accept that my final argument is based on an appeal to personal judgement. No doubt counter-arguments will be produced and more will need to be said. Yet even in advance of reply, it must be noted that the very need for counter arguments and further comment demonstrates that there are strong reasons for doubting that Adam Smith would have supported a flat tax regime. And that matters.
By calling itself the Adam Smith Institute, the ASI implies – deliberately or otherwise – that the policies it advocates are the intellectual heirs of the analysis expounded by the founder of modern economics. In turn, this serves to confer a sense of authority and intellectual legitimacy upon the ASI’s proposals: that these are not just tax policies; these are Adam Smith tax policies. To see the political efficacy of such a manoeuvre, compare the following: “The Adam Smith Institute” versus “The Right Wingers for Lower Taxes Institute”.
Restructuring UK income taxes to a flat-tax system would be a drastic and revolutionary step. It would overturn a decades-long consensus that the better-off contribute, as Smith put it, “something more than in proportion” to their income. Again, whether or not this would be a good thing is not an issue I am going to tackle here. The point is, we should ask questions of an institution which employs Smith’s name to help advocate a revolutionary change to our tax system, when there are serious reasons for doubting that the great man himself would have supported that revolution.
All quotes taken from Adam Smith, An Enquiry into the Nature and Causes of the Wealth of Nations, (Chicago: Chicago University Press, 1976)
[i] Volume II, Book V, pg 349
[ii] Ibid pg. 350
[iii] Ibid pg 351
[iv] At ibid pg. 358
[v] Ibid pg. 393
[vi] Ibid pg. 394
[vii] Ibid pg. 353
[viii] Ibid.
[ix] Ibid pg. 270
[x] Ibid pg.371
[xi] See for example ibid pg. 369-70
[xii] Ibid pg. 368
[xiii] Ibid pg. 373
[xiv] Ibid pg. 369
[xv] Ibid pg. 368. Sharp-eyed observers will note that this passage is ancillary to that quoted at X above. I have separated the passage in order to tackle to separate strands in Smith’s text: progressivist sentiments (which the ASI might attempt to appropriate) and the stated commitment to the rich paying “something more than in proportion”, (which they cannot so appropriate).
Abstract: The Adam Smith Institute is in favour of moving UK income tax to a flat-tax regime. Yet there are strong reasons to doubt whether a flat-tax regime would have been endorsed by Adam Smith himself, whose views on the distribution of the tax burden appear more progressive than a flat tax on incomes allows for. However by employing Smith’s name, the Adam Smith Institute implies that the founder of modern economics advocated their tax policies, thereby providing them with an authoritative intellectual legitimacy they may not in fact posses.
I
The right of centre think-tank The Adam Smith Institute (ASI) is in favour of a flat-tax regime for UK income tax. The ASI’s report, A flat tax for the UK – A Practical Reality (PDF), states: “the fundamental principle [of a flat tax] is that income should be taxed at a single rate of tax for all taxpayers.” Flat tax is thus an example of what is known as a “proportionate” tax.
The consequences of such a tax are as follows: if Albert earns £1million, and Bradley earns £15,000, and they both incur a flat-rate of (say) 20% income tax. Albert will pay £200,000 in tax and be left with £800,000, whereas Bradley will pay the lower absolute sum of £3000 in tax, but leaving him with £12,000. The rate of tax incurred stays the same at all income levels: whilst the absolute sum contributed by each taxpayer rises with income, the rate of tax incurred stays the same.
Given that Albert’s income in our example is so much greater than Bradleys, it may be objected that it is unfair for both to pay the same rate. This, it might be said, is because Albert could contribute at a higher rate to the society which is itself a pre-requisite for him being able to become (or stay) rich in the first place. Furthermore, Albert could make that greater contribution whilst still remaining considerably better-off than Bradley. Thus opponents of flat taxes will tend to argue that it is fair for better-off Albert to pay a higher rate of tax on some of his earnings than what worse-off Albert pays on all of his. Opponents of flat taxes therefore typically promote what are termed “progressive” taxation systems, under which the rate of tax increases as income increases, usually be establishing higher “bands” of taxation above certain income thresholds.
The standard reply of flat tax proponents to the charge of unfairness is to advocate a personal allowance for all earners, which is not taxed. For example, the ASI report suggests a tax-free personal allowance of £12,000 (almost twice that of the existing UK tax-free allowance). Proponents of flat tax thus argue that it doesn’t hurt the poorest, and by implication isn’t unfair in that respect: the poorest just wouldn’t pay income tax. Above the threshold level, however, everyone incurs the same headline rate, which the ASI believes is a fair way to distribute the tax burden. (It should however be noted that, as a consequence of this tax-free threshold, effective or marginal rates of tax do vary with income levels – even though the headline rate doesn’t – in a way they did not in our above example of a flat tax with no allowance. More will be said on this later).
So, under the ASI’s proposals, whether a person earns £20,000 or £10 billion a year, they would only incur a 22% headline rate of income tax, minus the initial tax-free allowance. This will still be found objectionable by proponents of progressive taxation, who believe that the rate of tax incurred should increase above certain income thresholds reflecting higher earner’s increased ability to pay, regardless of the presence of an enlarged tax-free allowance benefiting the poorest. Those, in essence, are the dividing lines (though more will need to be said about them in due course).
The aim of this paper is not to assess the merits or otherwise of a flat tax regime for UK income tax. Whilst the Tax Justice Network is certainly not in favour of flat tax regimes, the arguments as to why flat tax is undesirable have been articulated elsewhere (PDF). The purpose here is to explore the question of whether Adam Smith himself would have supported the ASI’s promotion of a flat tax regime. There are strong reasons to suspect he would not.
II
Adam Smith’s discussion of taxation takes place in Volume II, Book V of An Enquiry in the Nature and Causes of the Wealth of Nations. It would be easy to selectively cherry-pick quotations from this section and accuse the ASI of advocating policies at odds with Smith’s views. Yet it would also be somewhat disingenuous. Smith’s discussion of taxation is wide-ranging and complex. He does not set out to offer specifically normative recommendations, but instead provides an analysis laced with historical comparisons and periodic injections of value judgement. Thus to avoid the charge of selective representation, we must take some time to consider Smith’s views on taxation.
Smith thought that taxes were most certainly necessary. He considered “public stock and lands” as sources of state revenue, and declared them to be “insufficient funds for defraying the necessary expence of any great and civilised state.”[i] What was required to make up the shortfall was taxation.
Smith understood tax as being levied in five broad categories. Firstly, there could be direct taxation on the following three things: rent (including land and houses), profits arising from investments (“stock”), and wages. Additionally, there could be a general “capitation” tax levied on all individuals, which they would be expected to pay out of the first three categories as they saw fit or were able. Finally, there were “taxes on consumable Commodities”, or what we would now recognise as indirect taxes on the transactions of goods and services, for example VAT or sales tax.
An initial obstacle should therefore be noted: Smith did not discuss taxes on income in the modern sense. This is simply because income tax did not exist in its modern form when Smith was writing. Therefore to come to a conclusion as to whether Smith would have supported a flat-tax on incomes requires exploring his thought in other areas of taxation and inferring what his position on flat rate income tax would likely have been. Thankfully this is quite possible.
I will here focus on Smith’s discussion of taxes on wages and on rent. This is because I do not find his discussion of the other categories pertinent to the issue of inferring Smith’s likely views on flat-rate taxation. (I have written briefly elsewhere about some of Smith’s views on indirect taxes. As regards “capitation” taxes, Smith’s discussion appears especially irrelevant to modern debates due to contextual factors, and anyway Smith broadly thought such taxes to be unsuccessful and counterproductive. As regards taxes on “stock”, in the interests of intellectual integrity we should acknowledge here that Smith would certainly not have seen eye-to-eye with the Tax Justice Network. He is clear that he believes taxing profits from investment will cause investors to flee to other jurisdictions, and thus such taxes are pointless and should not be undertaken. On this point, Smith is certainly far closer to the ASI than the TJN).
Before turning to consider taxes on wages and rent, however, we must note Smith’s “four maxims” of tax: equality, certainty, convenience of payment and economy in collection. Smith believed these maxims were conditions that needed to be fulfilled as fully as possible for any tax regime to be worthwhile and desirable. It should be noted that these maxims are now outmoded and anachronistic, and a satisfactory modern tax system must go considerably beyond these conditions (PDF). Nonetheless, examining Smith’s maxims is important if we are to infer what his likely position on modern tax debates would have been, even if aspects of his thought are now practically outmoded.
Of equality, Smith says the following:
“The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the protection of the state. The expence of government to the individuals of a great nation, is like the expence of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. In the observation or neglect of this maxim consists, what is called the equality or inequality of taxation.”[ii]
At first-glance this passage appears to be a clear statement of a preference for progressive taxation and a rejection of the principles underlying flat tax regimes: people ought to contribute “in proportion to their respective abilities”. Yet a flat-tax regime does not increase the rate of tax upon those earning higher incomes, despite their increased ability to pay higher rates of taxation: everyone incurs the same rate minus an initial allowance. So would Adam Smith be against the flat tax?
We cannot conclude so quickly. Proponents of flat tax at the ASI could plausibly claim that Smith’s words are consistent with their policy, by arguing that because somebody on a higher income pays more tax in absolute terms (whilst incurring the same rate minus an initial allowance), that means that they are in fact paying in proportion to their respective abilities, and this is achieved by a flat rate tax. So to decide if Adam Smith would have opposed a flat tax regime we need to go considerably further than this one quote.
Having said that, we should let the sword of reason cut both ways and head-off a reply from the ASI that flat-tax would have been preferred by Smith on the grounds of being conducive to “certainty”. Smith’s second maxim – that “the time of payment, the manner of payment, the quantity to be paid, ought all to be clear and plain to the contributor, and every other person” – was considered of great importance by Smith:
“The certainty of what each individual ought to pay is, in taxation, a matter of so great importance, that a very considerable degree of inequality, it appears, I believe, from the experience of all nations, is not near so great an evil as a very small degree of uncertainty”[iii]
The ASI advocates flat tax in part because it is “simple”. They claim that because everyone knows what they pay and that amount is easily calculable, the compliance costs of paying are low and so the tax yield is high. Flat taxes are certain, for sure, and in the sense that Smith advocated. Yet it is clear that the flat-taxers have no monopoly on certainty, which is not the same thing as “simplicity”. There is nothing “uncertain” about an income tax regime that has progressive gradations of tax rates relative to income, especially in the UK where most income is taxed at source. A modern state can administer such a regime with as equal a degree of certainty as a flat tax regime. Smith’s prioritising of certainty over equality does not provide evidence of a support for flat taxes.
Similar things must be said of the other maxims, “convenience of payment” and “economy in collection”. The ASI promotes the flat tax in part because they claim its simplicity will lead to lower compliance costs and a higher tax yield. Can Smith’s insistence on “convenience of payment” be taken as evidence of his preference for a flat tax? Again, the answer is no: in terms of modern tax collection systems, there is no difference in “convenience of payment” (i.e. how one goes about paying-up to the state) between a flat-rate or a progressive taxation system. Whether the rate is 20% or 40%, the convenience of payment is the same (though the willingness may indeed by different, as the ASI is apt to point out).
As regards “economy in collection” (the efficiency of administering and collecting a tax), proponents of flat tax typically claim that their regime will prove more efficient to administer. This is because of e.g. the alleged virtues of simplification, the lowering of incentives to avoid and evade tax, and a claimed correlate reduction in the number of state employees needed to administer and collect tax. If this is indeed the case, then it might lend some support to the idea that Smith would have favoured a flat tax regime. This is, however, an empirical question, and insofar as the ASI is right or wrong about the answer to the question of increased efficiency, the claim to be representing Smith’s views by advocating flat tax stands or falls.
More importantly, “economy of collection” was not the defining factor for Smith in terms of what made a good tax regime. Even if a flat tax regime produces greater “economy in collection” than a progressive regime, it does not follow that Smith would therefore automatically have preferred the former. It is entirely reasonable to suppose that Smith would have tolerated a larger degree of diseconomy in collection in a progressive tax regime compared with a flat-tax regime, if the former yielded benefits or exhibited features that Smith held to be especially important. Indeed there is evidence that this was the case, as we shall see. It should also be noted that in his discussion[iv] of taxes on land rent, Smith states that although it is more expensive to tax on a basis of varying rather than fixed land-values, he believes this is a price worth paying for a better over-all tax regime. Economy in collection was clearly not the necessarily decisive factor for Smith.
III
Those preliminary matters established, we can now delve into Smith’s discussions of specific taxes to assess whether or not he would have backed a flat tax on income. As stated above, I shall focus only upon taxes upon wages and rent, as these are the most pertinent areas of Smith’s discussion for our purposes.
Having said that Smith’s discussion of “taxes upon the Wages of Labour” will not provide us with any answers (although it is important to consider his discussion nonetheless). This is because Smith thought that there should be no taxes on wages of labour at all.
His reasoning was simple: “While the demand for labour and the price of provisions, therefore, remain the same, a direct tax upon the wages of labour can have no other effect than to raise them somewhat higher than the tax”[v]. And Smith thought this would be terrible: the result would be effective higher wages, which would lead to economic stagnation. He laments, however, that “Absurd and destructive as such taxes are…they take place in many countries”[vi] (before going on to criticise the French, as he is apt to do at regular intervals).
Smith’s conviction that wages should not be taxed does not, however, translate into support for a flat rate of income tax. Just because Smith thought it was a bad idea to tax wages does not mean that, given the context of established income-tax regimes in the modern world, he would therefore have been in favour of everyone paying the same rate (albeit with an initial tax-free allowance). We simply cannot say, one way or the other, and that fact must be openly acknowledged.
By contrast, if we turn to what Smith says about taxes on the rent of land and houses, there is evidence that he was in fact strongly inclined towards proportionately increasing the tax burden on the better off.
Smith’s discussion of taxes on rent is long and detailed. It incorporates two broad aspects: taxes on land and taxes upon houses. Both are revealing insofar as they appear to demonstrate a clear preference from Smith in favour of progressive taxation over a flat tax regime.
We begin with taxes on land. Smith thought that taxing the “rent” from land had great potential as a source of revenue for the state. Considering land rent taxes assessed on a fixed valuation, Smith wrote that such a tax was “perfectly agreeable” to the three maxims of certainty, economy of collection and convenience of payment: “it subjects the landlord to no other inconveniency besides the unavoidable one of paying the tax”[vii]. However, Smith felt that such a tax “offends against the first of the four maxims”, equality.[viii] Accordingly, he advocated a system of taxing land rents based on variable valuations of land to eliminate that problem, thus making taxes on land rent a most desirable sort of tax.
Smith’s advocacy of a land rent tax is instructive. Although in this section he does not pass normative judgement about who should shoulder the tax burden, there is an obvious implication in Smith’s opinion that taxes on land rent are good and desirable. Then (as now) landownership was concentrated in the hands of a wealthy minority: if land rent taxes are a good and proper source of taxation, and wages on labour are not, the implication is clear that Smith thought it proper for the better-off to shoulder the tax burden. Now this, of course, does not translate into a concrete opposition to a flat tax regime. It merely indicates that Smith may have been in favour of the better-off shouldering the tax burden. For solid indications that Smith would not have backed a flat tax regime, we turn to rent on houses.
Smith was in favour of taxing the rent on houses: “Ground rents [on houses] and the ordinary rent of land, are, therefore, perhaps, the species of revenue which can best bear to have a peculiar tax imposed upon them.”[ix] Although Smith believed that taxing the rent on houses is really a tax on land-profit and wages (because houses don’t produce anything themselves), he goes on to say that “nothing can be more reasonable than that a fund which owes its existence to the good government of the state, should be taxed peculiarly, or should contribute something more than the greater part of other funds, towards the support of government.[x]”
It is the rich who, in seeking the biggest and most expensive houses, will typically incur the greatest taxes in house rent, and Smith thinks this is just fine. (Indeed, he apparently believes that taxes on house rent will encourage people to rent smaller houses and divert their spending into more productive channels than simply paying rent on a big house, thus benefitting the wider economy[xi].)
It is in his discussion of house rents, however, that Smith voices sentiments towards taxation that appear highly progressive in nature, indicating a preference for the better-off shouldering an increasing burden of tax:
“The inequality with which a tax of this kind might fall upon the owners of different ground-rents, would arise altogether from the accidental inequality in this division. But the inequality with which it might fall upon the inhabitants of different houses would arise, not only from this, but from another cause. The necessaries of life occasion the great expence of the poor. They find it difficult to get food, and the greater part of their little revenue is spent in getting it. The luxuries and vanities of life occasion the principle expence of the rich; and a magnificent house embellishes and sets off to the best advantages and the other luxuries and vanities which they possess. A tax upon house-rents, therefore, would in general fall heaviest upon the rich”[xii]
“The principal objection to all such taxes [window taxes] is their inequality, and inequality of the worst kind, as they must frequently fall much heavier upon the poor than upon the rich. A house of ten pounds rent in a country town may sometimes have more windows than a house of five hundred pounds rent in London; and though the inhabitant of the former is likely to be a much poorer man than that of the latter.”[xiii]
Are such sentiments that the rich should incur greater tax proof that Smith would have opposed a flat tax regime? We cannot conclude this yet, for two reasons.
First we must acknowledge a lurking problem I have so far deliberately ignored: that proponents of flat tax systems are fond of arguing that their preferred regime is in fact “more progressive” than what is traditionally termed a progressive regime. This generally relies upon the argument that a larger tax-free allowance than under (traditional) progressive systems, plus a flat rate tax, results in more progressive distribution of the tax burden because of the affect of a large tax-free allowance upon the effective or marginal rate of tax paid.
There are reasons to doubt the flat-taxer’s contention that their system is “more” progressive than an income tax regime with higher rates for higher earners above certain thresholds. For example, with the ASI’s scenario of a 22% flat tax and a threshold of £12,000, a person on £15,000 would pay £660 in tax, which is an effective tax rate of 4.4%. A person earning £100,000 would pay £19,360 in tax which is an effective rate of 19.3%. But it is important to note that this isn’t the end of the matter, because the effective rate converges asymptotically on a final flat rate. Someone earning £200,000 would pay £41,360 which is an effective rate of 20.68%. As income increases upwards towards the millions and billions, the effective rate of tax paid gets ever closer to 22% (though because of the mathematical limit, cannot ever reach it).
The result is as follows. At the lower ends of the income scale, because of the tax free allowance, a considerable progressivity of effective tax results: compare the 4.4% rate with the 19.3% rate in our example above. Yet as income increases the progressivity of a flat tax decreases because the effective marginal tax approaches the mathematical limit of 22%. This means that above the mark of around £60,000, the flat tax begins to lose meaningful progressivity, because earnings over that sum bunch ever closer to the 22% mark. This means that the richest see only tiny increases in the effective marginal tax rate incurred. This would not be the case if, as under a progressive tax system, they incurred a higher rate of (say) 40% on income over a certain threshold. Thus there are strong reasons to doubt that flat tax is “more progressive” than progressive taxation.
However, to the extent that proponents of the flat tax continue to claim that it is more progressive than progressive taxation (as that term is usually understood), it is no use citing passages of Smith where that author exhibits a merely progressive sentiment. The flat-taxers will claim that as evidence that Smith supported a flat tax.
The second objection is that Smith writes the following: “A proportional tax upon this particular article of expence [house rent] might, perhaps, produce a more considerable revenue than any which has hitherto been drawn from it in any part of Europe.”[xiv] And this, it might be argued, is evidence that Smith supported proportional – i.e. flat – taxes.
Are these objections decisive? The answer is no, for the following reasons.
To take the second objection first, it is clear that Smith is simply observing that a proportional tax on house rents would likely produce a “considerable revenue”, and more so than other established systems of tax at his time. It is not a declaration that taxes should only be proportionate. There is nothing to suggest Smith would rule out a further, compatible thought: house rents should rise in proportion as the article of expense increases.
Indeed, there is in fact evidence that he thought precisely this. And it is, conveniently, the same evidence which indicates that Smith was in favour of progressive taxation as traditionally understood rather than in revisionist senses promoted by flat tax advocates by focusing on marginal rates at the lower end of the income scale. For Smith writes:
“A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be any thing very unreasonable. It is not very unreasonable that the rich should contribute to the public expence, not only in proportion to their revenue, but something more than in proportion.”[xv] (emphasis mine)
Two things are important to note here: firstly, this sentiment is apparently being applied not just to house rents, but to contributions to the “public expence” generally. It can thus fairly be applied to other areas of taxation, and used to infer what Smith would have thought about taxes more widely than just those concerning house rents. Secondly, and crucially, it is a clear statement that the rich ought to contribute “something more than in proportion” to their revenue; a statement that could be equally well expressed by saying that the rich should incur higher rates of taxation.
Of course, the issue is not settled decisively. The ASI could claim that when Smith states that the rich should pay “something more than in proportion”, a system whereby rising incomes were taxed at a limit approaching 22% (bunching ever closer to that figure), would have satisfied him. Here we must exercise our discretion. Do we think this is in fact the case, or do we believe it more likely that Smith would have favoured a progressive tax system whereby higher earners do not just incur marginal tax rates increasing towards 22%, but rather incur higher headline rates of tax over certain income thresholds? I would suggest that, given the tenor of the above remarks, and the tendency of a flat rate tax to increase the marginal rate of tax by only very tiny amounts for ever higher incomes, it is more plausible that Smith would have favoured progressive taxation than a flat tax.
IV
I do not present this analysis as conclusive, and accept that my final argument is based on an appeal to personal judgement. No doubt counter-arguments will be produced and more will need to be said. Yet even in advance of reply, it must be noted that the very need for counter arguments and further comment demonstrates that there are strong reasons for doubting that Adam Smith would have supported a flat tax regime. And that matters.
By calling itself the Adam Smith Institute, the ASI implies – deliberately or otherwise – that the policies it advocates are the intellectual heirs of the analysis expounded by the founder of modern economics. In turn, this serves to confer a sense of authority and intellectual legitimacy upon the ASI’s proposals: that these are not just tax policies; these are Adam Smith tax policies. To see the political efficacy of such a manoeuvre, compare the following: “The Adam Smith Institute” versus “The Right Wingers for Lower Taxes Institute”.
Restructuring UK income taxes to a flat-tax system would be a drastic and revolutionary step. It would overturn a decades-long consensus that the better-off contribute, as Smith put it, “something more than in proportion” to their income. Again, whether or not this would be a good thing is not an issue I am going to tackle here. The point is, we should ask questions of an institution which employs Smith’s name to help advocate a revolutionary change to our tax system, when there are serious reasons for doubting that the great man himself would have supported that revolution.
All quotes taken from Adam Smith, An Enquiry into the Nature and Causes of the Wealth of Nations, University of Chicago Press, 1976
[i] Volume II, Book V, pg 349
[ii] Ibid pg. 350
[iii] Ibid pg 351
[iv] At ibid pg. 358
[v] Ibid pg. 393
[vi] Ibid pg. 394
[vii] Ibid pg. 353
[viii] Ibid.
[ix] Ibid pg. 270
[x] Ibid pg.371
[xi] See for example ibid pg. 369-70
[xii] Ibid pg. 368
[xiii] Ibid pg. 373
[xiv] Ibid pg. 369
[xv] Ibid pg. 368. Sharp-eyed observers will note that this passage is ancillary to that quoted at X above. I have separated the passage in order to tackle to separate strands in Smith’s text: progressivist sentiments (which the ASI might attempt to appropriate) and the stated commitment to the rich paying “something more than in proportion”, (which they cannot so appropriate).
Linky love 6th January « Left Outside said,
January 6, 2010 at 11:03 am
[...] Paul Sagar has an excellent post if you are interested in Adam Smith… and a really excellent post if you are really interested in Adam Smith here. [...]
Mark said,
January 12, 2010 at 4:06 am
Very interesting.
I`m not convinced that Adam Smith (or any sane person), would be overly concerned that an immensely rich person was only paying a slightly higher percentage of his income in tax than a very rich person was.
Given that this appears to be the only stumbling block to Adam Smith`s “support” of the policy and that otherwise all of the Adam Smith boxes are being ticked, I don`t think it`s misleading for an institute bearing his name to suggest such a policy.
Nice try though.
Tim Worstall said,
March 29, 2010 at 8:44 am
I’ve only just noticed this piece. You seem to get a tad confused a couple of times. Where you’re using “effective” tax rates most would say “average”. And under a flat tax system of course average (or if you prefer, effective) tax rates do vary….but marginal ones don’t (well, if we’re to be really picky, there are two, 0 and 22%).
The other thing is you elide between ground and land rents and house rents. Not the same thing at all. The former are very much something to be taxed, the least distorting of all taxes (as Friedman noted, as did Ricardo and Henry George built a whole system on the point).
But it is the land which is taxed, not what is built upon it. The cottage on an acre of Mayfair should be paying the same tax as the mansion on an acre of Mayfair. For it’s the acre of Mayfair which is the scarce good, not the cottage or the mansion.
Other than that you’re right, it’s very much a matter of opinion. Does a rising average tax rate although a static marginal one meet the test of “greater than proportion”? I’d say yes, you no.
And as to the necessary snark:
“in proportion to the revenue which they respectively enjoy under the protection of the state.”
Therefore, revenue which is not enjoyed under the protection of the State should not be taxed by said State. Revenue earned abroad and left abroad should not be taxed….we are all non-doms.
Yes, the ASI has been known to say that.
William Davison said,
March 30, 2010 at 10:38 pm
I think its a stretch to say Adam Smith would support our so called progressive taxation. For starters the tax system is not really progressive, unless you exclude National insurance. NI is a tax based on income, with a weak link to the benefits, other taxes are required to support the welfare state. Until recently we only had 2 Income tax rates 20 and 40%, most 20% rate payers paid national insurance at 11% and their employer paid another 12.8%. When you combine their Income tax, employee NI and employer NI, the net marginal tax rate paid by the employer in PAYE is about 38%. As the employee goes on to the higher 40% rate, they largely stop paying the NI. So the tax system is almost flat already! i.e. progressive taxation is largely a lie.
Income tax should return to what it was, a tax on the rich not the poor, it makes little sense to tax people on incomes as low as £6500 which they cannot possibly live on and then give the money back in complex tax credits.
Consider this, if the Income tax allowance started at £15000 (below that is considered low pay) and NI is scrapped, you could have a single flat 35% income tax rate that would not increase the overall income tax burden on anyone, be a lot simpler and probably more difficult to avoid. I suspect the tax recovery rate would improve on this lower tax rate and the rest would be recovered by a land value tax as Adam Smith proposed. Also other taxes could be scrapped and reduced, if land taxes were adopted.
A major problem with progressive taxation is it is so easy for the rich to avoid and the incentive for special interest groups to argue for tax breaks and accountants to find way avoid it becomes greater the higher the rate. Land taxes are almost impossible to avoid and cheap to collect. Progressive income tax, has an unintended consequence of blinding many on the left to taxes on Wealth and getting people on middle incomes to often pay higher marginal rates than the rich who can convert their income into capital gains at lower rates or move it off shore.
How to think about…The Wealth of Nations « Bad Conscience said,
August 25, 2010 at 8:01 am
[...] you find stuff that would give any modern neoliberal a coronary. Paul has already pointed out on another post what Smith says on taxes and how the rich should pay proportionately more. But it’s also worth [...]