Adam Smith and Modern
Public Revenue Policies

David Hillary, Bryan Kavanagh,
Harry Pollard and Dan Sullivan

[Reprinted from a Land-Theory online discussion, September 2002]

DAVID HILLARY

In 1776 Adam Smith's Inquiry into the Nature and Causes of the Wealth of Nations was published. Sadly, while this book is very well known and highly respected, its insights into political economy and taxation appear to be poorly understood and little applied to modern public revenue policies. The purpose of this document is to highlight these insights and apply them to Land Value Tax (LVT).

Adam Smith begins his analysis of taxation rightly by considering its ultimate incidence: the sources of Rent, Profit and Wages. "Every tax must finally be paid from some one or other of those three different sorts of revenue" (Book V, Chapter 2, part II). Next Smith outlines the basis on which the merits and demerits of taxes should be measured by, listing the following:

Firstly, in what Smith calls "equality in taxation," the incidence of taxation, on any source should be "in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state".

Secondly, the tax should not be arbitrary. Arbitrary taxation puts the people at the mercy of the State and corrupts public officials, Smith states. Importantly, Smith puts this as a higher ranking than equality, meaning that it is better not to impose a tax on an item of income from an otherwise taxable source, if the tax on that item would be arbitrary: "a very considerable degree of inequality, ... is not near so great an evil as a very small degree of uncertainty."

Note that the first two maxims are stated in moral, social and political terms, rather than as "expense" items. Taxation can be, but need not be, a cause of discrimination, fear and corruption of the state. Equality under the law, and due process of law should not be an afterthought in taxation policy.

The Third and Fourth maxims can be combined: "every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state." Smith outlines four ways that taxes can impose an excess burden or deadweight cost:

1. Administrative costs that use up a proportion of the revenue collected.

2. Compliance costs imposed on payers in addition to tax payable including their 'trouble, vexation and oppression' from 'odious examination' etc.

3. Economic deadweight losses from substitution away from more viable taxed activities towards less viable but less taxed activities.

4. Losses from destruction of welfare and production of those who are punished for non-compliance.

On this basis we will consider the place, operation and reform of the the tax.

We begin, Like Adam Smith, with 'Taxes on the Rent of Land' (Book V, Chapter 2, Article 1). This is the first of his three sources of revenue which can ultimately bear the burden of a tax. We should firstly examine why the rent of land ought to be subject to peculiar taxation and secondly why that peculiar taxation should be Land Value Taxation (LVT) and finally how should such a LVT to administered and assessed.

Smith consider the Rent source in quite some detail and promotes it as "the species of revenue which can best bear to have a peculiar tax imposed upon them [because they] ... are altogether owing to the good government of the sovereign, which, by protecting the industry [of the] people... enables them to pay ... for the ground which they build their houses upon ... 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 that government."

Because land is not produced by its owner, and the ground rent of land is, by definition, excluding the revenue from any improvements or labours on it, tax on this rent causes "no discouragement ... to any sort of industry. The annual produce of the land and labour of the society, the real wealth and revenue of the great body of the people, might be the same after such a tax as before."
This is the same as a fixed land-tax of which he says:

"it has no tendency to diminish the quantity, it can have none to raise the price of that produce [of land]. It does not obstruct the industry of the people. It subjects the landlord to no other inconveniency besides the unavoidable one of paying the tax."

In the economic jargon, the supply of land is perfectly inelastic, and so a tax on rent causes no change in the quantity supplied and no loss of output. This means that a tax on ground rent cannot be passed on, it falls entirely on rent: "A tax upon ground-rents would not raise the rents of houses. It would fall altogether upon the owner of the ground-rent, who acts always as a monopolist, and exacts the greatest rent which can be got for the use of his ground. More or less can be got for it according as the competitors happen to be richer or poorer, or can afford to gratify their fancy for a particular spot of ground at a greater or smaller expence. ... As the wealth of those competitors would in no respect be increased by a tax upon ground-rents, they would not probably be disposed to pay more for the use of the ground. Whether the tax was to be advanced by the inhabitant, or by the owner of the ground, would be of little importance. The more the inhabitant was obliged to pay for the tax, the less he would incline to pay for the ground; so that the final payment of the tax would fall altogether upon the owner of the ground-rent."

Smith desired such a tax but noted that:

"Though, in many different countries of Europe, taxes have been imposed upon the rent of houses, I do not know of any in which ground-rents have been considered as a separate subject of taxation. The contrivers of taxes have, probably, found some difficulty in ascertaining what part of the rent ought to be considered as ground-rent, and what part ought to be considered as building-rent. It should not, however, seem very difficult to distinguish those two parts of the rent from one another."
Instead he proposed modification of the British land-tax to turn it from fixed valuations to taxes on the rent on registered leases, with penal rates on a number of lease arrangements he considered undesirable. Smith then tries to redeem his interventionist indulgence by contradicting himself with:

"The principal attention of the sovereign ought to be to encourage, by every means in his power, the attention both of the landlord and of the farmer, by allowing both to pursue their own interest in their own way and according to their own judgment; by giving to both the most perfect security that they shall enjoy the full recompense of their own industry; and by procuring to both the most extensive market for every part of their produce, in consequence of establishing the easiest and safest communications ... through every part of his own dominions as well as the most unbounded freedom of exportation to the dominions of all other princes." The contemporary method of taxing land, typically employed by local and/or state governments, is to rate or tax unimproved land value. We will consider this under the heading of Land Value Tax (LVT).

The unimproved value of land is the discounted expected future net ground rent. Land Value Tax (LVT) is a tax on the unimproved value of land and therefore falls exclusively on ground rent. No penalty is given to improvements or labours on that land, and no discouragement is given to putting land to its most productive and valued use. No preference is given to one use compared to another, or for ownership or control of the land to be vested in one person compared to another.


Principles of Land Value Taxation

1. All land in the territory of the taxing government should be assessed for LVT. Not an single square meter of territory should be exempt. The Land Titles Office should account for the ownership of the entire territory and keep a title database recording the location, size, boundaries and other fundamental details of each site, for the purposes of value modelling and LVT assessment.
2. The rate of LVT should be uniform and flat, regardless of ownership, use, disuse or improvements.

3. Unimproved land values should be regularly and accurately assessed for LVT purposes. This can be done by monitoring prices paid for sites for redevelopments, monitoring prices paid and deducting the depreciated replacement value of improvements and monitoring other indicators of the market.

4. Titles to be forfeited to the Tax Authority before overdue taxes exceeds value of the property.
Measured against Adam Smith's four maxims, the tax is equal on all income from this source (such income being a good proxy for the protective and productive advantages derived from the state), the degree of certainty is high, the administrative expense is very low, compliance and punishment costs negligible and the economic deadweight is zero. In fact a less offensive or burdensome tax will not be found.


BRYAN KAVANAGH

That's pretty good stuff, David.

Similarly, I like to pare things back to the basics, and, although I'd argue that the attachment based on George does this, one could go even further [if it is accepted that capital is simply 'stored up' labour] to say that we may either draw revenues from land or labour. Those derived from labour are pernicious in that they penalise labour, may be passed on in prices, and set up pathologies, whereas those from land allocate scarce resources efficiently, tend to conserve them, cannot be passed on in prices, and create no pathological externalities.


HARRY POLLARD

Bryan, "Capital" doesn't seem like 'stored-up labor' to me. It's a product of labor. That's all. Some of the product is kept in the producing process. We call it Capital. Some is in the hands of the consumer. We call it Wealth.

Capital isn't really a store of value at all. When it's used, it wears out and must be constantly replaced to maintain it's value.

We have a lot of stored up labor in the US called roads and bridges. They aren't being maintained and the 'store' is rapidly diminishing.

Sort of reminds one of that other 'store of value' - money.


BRYAN KAVANAGH

You are quite correct, Harry. Capital is a stored up admixture of land and labour, which does depreciate, but it is a secondary, albeit very important, good or resource, being neither a natural resource nor a human factor.


DAVID HILLARY

Capital is property. If you can't say its yours you have to write if off.

Capital is an asset. If you cannot expect any economic benefit from it you have to write it off.

Capital is a produced good. If no value has been added to it, its a natural resources, a non-produced asset. If a natural resource has any value added= to it it becomes a produced good, capital.

Capital is durable. If it cannot last whatsoever, its a service or something else.


DAN SULLIVAN:

David Hillary wrote: "smith wrote:

A tax upon the rent of land which varies with every variation of the rent, or which rises and falls according to the improvement or neglect of cultivation, ... are the taxes which fall finally upon the rent of the land, and what are those which fall finally upon some other fund.

Do you think he correctly understood their position? do you think he is correct?"

I suppose only a scholar of the physiocrats can know precisely what they had advocated. I have read only sketchy excerpts of translations. George seemed to think they would tax all land whether in use or not, while Smith, in other writings, seemed to think that the tax would be on the rent collected.

This led Ricardo to rebuff Smith's contention that the land tax would not be passed on. He developed the law of rent to show that Smith's tax only on rent collected would indeed be passed on, and that only a tax on all land would fall on the landholder instead of the user. Of course, if all taxes come out of rent, then so does Smith's tax. The failure is that it does not prevent rack-renting, or artificially jacking up rents by creating an artificial scarcity.

However, I do agree that all taxes ultimately come out of rent, as they tax the various uses to which one can put land, and therefore reduce its rental value. The advantage of land value tax is that it does not discriminate against land that is put to use, and does not allow landholders to create an artificial scarcity.