1.1.18 Public income and expenditure

In highly industrialised countries, the government collects more or less 1/5 of the GDP through taxes and other 1/5 through the different types of the public social systems (health service, pension system, unemployment, insurance).

In other words, 3/5 of the GDP is controlled by markets and 2/5 are spend without any control. In the academic curricula, only the first part is studied and the other 2/5 are silently ignored.

That's curious; because the market mechanisms are so easy to understand, that there is actually little to study. The market is actually something "natural". If the government does simply nothing, but secures the acceptance of some simple rules, we have a market economy.

That's the strength of market economies. They are so simple, that everybody understands how they work. Or if we want to be more precise. Even is people don't understand why prices rise, they adapt themselves to a change in the price structure, whatever the reason for this change may be.

Modern textbooks on microeconomics focus on the analyses of markets. We can say as well that they only address markets. This explains in part, the success of neoliberalism. Neoliberalism addresses the impact of governmental activities. It fills a gap, although the solutions offered are not very convincing, see governmental activities.

With 2/5 of the GDP, the tax payer provides the government with power. In other words, the tax payer provides the government with an enormous amount of resources and power without knowing what he really gets for this money. That's means that

- Education
- Research and Development
- Culture
- Redistribution
- Justice and Security

are sectors without any control. Nobody knows how much money is spent in these sector, for what it is actually used for and if there are more efficient alternatives. It is true that we don't know neither anything about the internal structures of companies, but there is no need to know that. We don't care how a smartphone is produced. We compare prices in relationship to the quality and don't care about the rest. There is a mecanism of control. We don't know why company X is more efficient than company Y, but we know, that it is more efficient.

That's not the case with governmental activities. The city and federal state of Berlin for instance subsidises EACH NIGHT the culture, concerts, opera, theater etc. with 1/2 million of euros, but nobody actually knows what they do with this money. Another funny example of this type is the Goethe Institut. About this institution we have a little article on the internet, stop the Goethe Insitut.

However, isolated cases serves only to illustrate the basic problem. They are not very interesting in itself. It is a systemic error, see governmental activities.

Adam Smith and David Ricardo discuss taxes only under the perspective of their influence on allocation and who actually bears it, see below.

In the course of history, an infinite number of functions have been added to the original function to generate income for the government. Nowadays, taxes should internalise external costs, promote economic activities in structurally weak regions, promote the consumption of goods considered meritory goods or prevent people from consuming goods considered harmful. With taxes, the government tries to promote saving or spending and to smoothen out the differences in income and fortune.

Very often, we get some funny effects. In most countries, for instance, there is a heavy tax on tobacco but the same countries very often subsidise the production of tobacco. This is the case for instance in Germany, but it is to presume that all producers of tobacco do that. (For instance the USA, see Tobacco Subsidies in the United States totaled $1.5 billion from 1995-2012).

If the government believes that tobacco is harmful, without any doubt, it should simply prohibit it, as it is the case with marijuana. (Although this is not very logical neither. Alcohol is more harmful, especially because it consumed by almost everybody, but is not prohibited.)

Very often, the alleged arguments for the adduced arguments aiming to justify the taxation of certain goods are a mere pretext. In the case of the taxes on tobacco, it is argued that tobacco causes heavy costs in the health system. That may be true, but that doesn't justify the taxes. In Germany,, for instance, the situation is similar to other countries, the tax revenue of the tax on tobacco amounts to 10 percent of the total costs of hospitalisation. It is doubtful that 10 percent the hospitalisation costs are due to the consumption of tobacco.

A similar case is the vehicle tax. It is argued that the owner of cars should pay for the maintenance of streets and roads. The problem is, that in most countries, the income of the vehicle tax exceeds the money spent for the maintenance of the streets and roads.

What is really funny is the so called eco-tax; a tax on fuel. With this tax, in Germany, two aims are pursued. Promote the production of less consuming cars and, that's no joke, to support the pension system. That means that even people who never will get any money from this system are obliged to pay for it and if one goal, the reduction of fuel is obtained, the other goal cannot be obtained.

The examples are not relevant, they serve just as illustrations. It is obvious that if several bureaucracies pursue an infinite number of goals with the same means, they will produce an infinite number of contradictions especially if there is no control at all and if every bureaucracy has it's own interests.

Most of the taxes discussed by Adam Smith are indirect taxes. In other words, they are imposed on production factors or consumption goods. Concerning the few direct taxes adressed by Adam Smith, taxes imposed on the rent, they can never, as Adam Smith assumed, be passed to the consumer.

Direct taxes are always taxes on the income if this income is different. A proportional tax on the income leads therefore, to different taxes and cannot be passed to a third person because that would lead to different prices, which will not be accepted by the market. Only in the very special case assumed by Adam Smith and David Ricardo, that the income is on the level of the subsistence level they can be passed, because in this, case all the competitors are obliged to raise the prices.

People can have two kind of incomes. From their labour or their capital. Even if the incomes are equal, the situation is obviously not the same. It makes a big difference if someone gets 3,000 dollars working 8 hours a day or if he gets 3,000 dollars from capital. It would be therefore fair to impose a higher tax rate on revenues of capital. That's not always the case.

The only thing everybody agrees is that the tax rate should increase with increasing income. The argument is that money follows the same rule as any other good. The more someone has it, the less it the utilitiy of this money. If for a rich man 1,000 euros provides the same benefit as 100 euros for a poor man, then it would be fair that the rich man pays 10 times more taxes.

By the way, fortunately the Marxist, classical/neoclassical idea that savings, not consumed incomes from the past, are the condition for investment is not true. If this were the case, the people who have money will get more money, because only they have the possibility to invest.

There are infinite number of problems with the progressive tax rate, more than proportional, although it sounds fair at first glance. If the income varies a lot from year to year, then the people whose incomes are unequal every year, entrepreneurs in general, are worse off. If they earn very little one year and a lot the next year, they pay more taxes as they would earn the same every year.

Other problems arise if some taxes are imposed by the municipalities, others by the federal state and others by the central government. The idea behind is that there should be competivity between the different regions. If people wish more public services, swimming pools, theaters, museums, libraries etc.. they should have the possibility to make a choice. They pay more taxes and they get more service.

That would be perhaps a good idea, if all the inhabitants of a municipaly pay for these services, but actually only the companies pay and they see it a different way. They don't want to pay alone for the service provided to all. Therefore, we get a competition between the different municipalities. Companies go to the municipality which charges less.

It is argued as well that some communities offer a better infrastructure than other and can therefore charge more. That's not really a convincing argument, because the infrastructure, the existence of universities, proximity to a railway station/port/motorway, already existing companies which provide the products and services needed etc. has little to do with the politics of the municipality or the federal state.

Besides that, it is contradictory. Taxes are normally imposed by the biggest entity in order to reduce, by transfers, the unequal living conditions in the different regions. Under this perspective, it is not very clear why certain regions should be better off than others.

Besides that, in order to raise these taxes, a new bureaucracy is needed and very often, the same productive factor is taxed twice; one time by the government and one time by the municipality.

Almost all countries tax corporations in a different ways than partnerships. It is unclear why. The only thing which is true without a doubt is the fact that two different tax systems complicates the system and makes the tax collection more expensive for the public administration and for the company.

Equally strange are taxes upon the property, land, houses and other goods. If the taxes exceed the income, it is tax on the substance, in other words the fortune decreases. (And eventually must be sold to pay the taxes.) If it is not the aim to reduce the fortune, then it would be more intelligent to tax only the income generated by this fortune. (Something easier to do by the way, because the income has a lovely dollar sign and it is pretty clear what it is. Fortune must be evaluated by sophisticated fictions, which is always wrong.)

It can be argued that a tax on the fortune is fair because big fortunes are very often inherited. That may be true, but if the fortune doesn't generate income, it is worth nothing. It would be more logical to just tax the income. It can be argued that it is unfair, that some people live from their fortune and other people have to work to get the same income. That's true, but in this case, the income derived from capital should be taxed higher, what, in most countries, is not the case.

In summary, besides generating income, governments should pursue an infinite number of goals, some of them incompatible and others not compatible with a free market economy. If the government for instance, subsidises investment in some regions or in certain sectors of the economy, the profits won't correspond to the actual "natural" profits. If the government for instance subsidises the housing sector, tt can be more profitable to invest in the housing sector than in high-tech microscopes.

In a situation of unemployment, this is not a big problem. In a situation of unemployment, a country can construct houses and high-tech microscopes if housing is financed by an increase of public debts. However, if the government finances the housing by taxing high-tech companies, we have a reallocation from profitable sectors to less profitable sectors. That's not going to work in the long run.

The same thing is validly related to promoting certain regions. To give an example. In order to finance the infrastructure in East-Germany after the fall of the wall in 1989, an extra tax was imposed in order to finance that and it led to the situation in which the infrastructure of the almost deindustrialised East-Germany was better than West-Germany. That's not very useful neither.

In this kind of situation, it is better to pour more money into the system, lower the interest rates and to finance this kind of investments by loans. In the case of infrastructure, the next generations inherits fortune and therefore they can inherit debts as well.

The analysis we find in textbooks of the value added tax is simple, but tells us only half of the story. It is clear that a value added tax has a similar effect as costs. The marginal supplier is obliged to pass this tax to the consumer, otherwise he would be obliged to abandon his business. If the marginal supplier raises the price, the other suppliers can raise the prices as well. The market price of the good will rise and if we assume that the supply curve and the demand curve are elastic and react to a change in the price, the amount will decrease.

That's what we find in textbooks, but that's only half of the story. There are goods people have to buy at any price, bread, milk, vegetables, clothes and so on. If they have to spend more money for that, they will have less money for other things. In other words, not all the sectors are equally concerned by the add value tax.

The sums are not negligible. In highly industrialised countries, the subsistence level for a family with four persons is something around 14,400 euros a year (without rent, contribution to public health, pension system). The add value tax is between 15 and 21 percent, depending on the country. That means, if we calculate with 19 percent, 2,700 euros a year. We have the strange situation that the government imposes a tax on the subsistence level, in other words on food, and subisdises at the other side the production of food. This is an unfair redistribution. It would be better, and less bureaucratic to eliminate the customer duties on agricultural products as well as the add value tax on food.

It is often said that the add value tax promotes saving and has therefore, a positive impact on economic growth. The logic behind is simple. The only way to avoid the add value tax is to consume less and therefore people will consume less. The argument is obviously foolish.

The investors are companies. Companies don't care if the bank system expands the amount of money when they lend money through the banking system or if they borrow the money themselves from their customers. In both cases, the companies have to pay back the credit. At the other side it is hard to see why investors should invest if people save more money and spend less.

A reduction of consumption, saving, make sense, if the economy is not able to satisfy the demand. If demand exceeds the supply, prices will rise. The problem is that since 30 years, we've not had a demand driven inflation.

In a lot of economic thinking survives some basic classical wrong conceptions, what leads to a lot of errors, as we have already seen and will see througout this manual. Saving in classical thinking is defined as not consumed incomes of the past. This definition leads nowhere. The right definition is this one: Saving must be defined as production of capital goods instead of consumption goods. That means that there is no need for saving in the case that both can be produced and saving is necessary, if the production of capital goods is only possible at the expense of the production of consumption goods.

That means that saving is only necessary in case of full employement and not needed in case of underemployment.

That means that saving is something very different at the level of the individual market player than at the level of the economy as a whole. Capital, actually money, can be scarce at the level of the individual market player, but money is never scarce at the level of the whole economy.

Besides that, a tax on the added value is a tax on every expenditures necessary to produce the product. If the entrepreneur pays let's say 3,000 dollars to his workers, including every kind of contribution to the social system, insurance against unemployment, public health, pension system a tax on the added value is a tax on these costs as well. The price a product is sold has to cover all the costs, obviously. If these costs are higher, the tax on the added value will be higher as well.

We will see when talking about David Ricardo, that only if we suppose extreme situations, for instance if wages can never be higher than the subsistence level, the effect of taxes are predictible. In any other situation, the effects are unpredictible and contradictory. It is plausible that one single tax on profits of any kind, earnings, wages, yield on capital, and interest yields without any distinction between jurisdiction persons and natural persons would be as just or unjust as the actual tax system with hundred of taxes, but the costs of tax collection, in the private sector and the government, would be lower.

(The costs of tax collection amount in Germany for example up to 4.7 percent of the fiscal revenue. If this sum is not included, there will be more elevated costs in the private sector.)

Tax consultants are in general able to calculate the taxes, because it is a formalised process, but none of them are able to explain the logic of the tax system in case that there is one.

Adam Smith discusses a tax that doesn't exist any more nowadays which is a tax on the rent to pay for an apartment. The following paragraph can only be understood if the assumptions are understood.

Adam Smith assumes that a tax on the rent will be passed to the tenant. If we remember what has been said in the chapter elasticity of the demand, we know that Adam Smith was well aware about the fact that it depends on the elasticity of the demand whether a tax can be passed to the consumer or not. If in this paragraph Adam Smith assumes that the tenant is going to pay the tax, it is because he assumes that there is an excess of demand in the housing market.

If things of primordial necessity are scarce, people will forego more luxurious goods in order to survive.

Let us suppose, for example, that a particular person judges that he can afford for house-rent all expense of sixty pounds a-year; and let us suppose, too, that a tax of four shillings in the pound, or of one-fifth, payable by the inhabitant, is laid upon house-rent. A house of sixty pounds rent will, in that case, cost him seventy two pounds a-year, which is twelve pounds more than he thinks he can afford. He will, therefore, be content with a worse house, or a house of fifty pounds rent, which, with the additional ten pounds that he must pay for the tax, will make up the sum of sixty pounds a-year, the expense which he judges he can afford, and, in order to pay the tax, he will give up a part of the additional comfort which he might have had from a house of ten pounds a-year more rent.

aus: Book V, Chapter II

Adam Smith supposes that the tenants will move immediately if the price of the apartment becomes more expensive. That's obviously not true. In the case of a shortage in the housing market, people can't move to smaller apartments because they don't exist. It is to assume that part of the tax on a rent will be paid by the house owner. (The same thing is valid for the taxes that actually exists, the taxes on property.)

In the case of the merchant discussed earlier, he gave a reason why the tax can be passed to the consumer. If the merchants are already on the subsistence level, all of them are obliged to pass the taxes to the consumer or to give up.

For an unknown reason, Adam Smith supposes here that the homeowner is in a better position.

[A similar error is made by Karl Marx and David Ricardo. Both suppose that it is possible to squeeze out of the workers the added value. However, even if this were the case, even if the capitalists only had to pay the subsistence level because work was available at any qualification in any amount it is hard to see how the capitalist can squeeze out the added value and why this added value is not eliminated by competition. This is only true, if capital is scarce and labour exists in abundance and can be the otherway round as well and actually it is the other way. Capital, actually money, is not scarce. It can be printed in any amount. Innovation and know how is scarce.]

It is a curious phenomenon with fatal consequences and interesting from a psychological point of view that in any textbook about economics, the word capital is used at least one hundred times without defining the term. It is curious how terms can narrow the perspective.

The building-rent is the interest or profit of the capital expended in building the house. In order to put the trade of a builder upon a level with other trades, it is necessary that this rent should be sufficient, first, to pay him the same interest which he would have got for his capital, if he had lent it upon good security; and, secondly, to keep the house in constant repair, or, what comes to the same thing, to replace, within a certain term of years, the capital which had been employed in building it. The building-rent, or the ordinary profit of building, is, therefore, everywhere regulated by the ordinary interest of money.

Book V, Chapter II

There are a lot of mistakes in this paragraph and we can find this kind of error until nowadays every day in any newspaper. The first mistake is that Adam Smith assumes that capital, in other words money, is a condition for investments, is something scarce.

If it were actually scarce, it should be used in the most profitable way. If capital is scarce, it actually competes with other investments and should be used in the most profitable way. If is not scarce, it can be used in any way.

We have to see that Adam Smith uses capital and money as synonyms. He speaks of capital, '...same interest which he would have got for his capital...', '... the capital which had been employed in building it...", but at the end of money, '...everywhere regulated by the ordinary interest of money...'.

This is strange because his friend, David Hume, was already well aware, see balance of trade, that in increase in gold, at that time a universal means of payment, can promote the economic activity. Besides that, Adam Smith himself was well aware that banks could increase the amount of "money" by issuing bills of exchange or by acting as a guarantor, see trade balance, he is not able to get rid of the idea that capital, actually money, is needed for investments.

If all investments were financed with 'capital' in the sense of income not consumed of the pass, the amount of money would never increase. In this case, a growth of the GDP would be only possible, if we assume a constant velocity of money, if the prices fall. That never happens. Not in the time of Adam Smith and even less nowadays.

The next error is a direct consequence from the first one. Adam Smith says that the use of capital in one sector, the housing sector in this case, competes with the use of capital in another sector and will be invested in the housing sector only if investments in the housing sector are more profitable. This would be true If capital, actually money, Adam Smith uses the two terms as synomyms, would be scarce. Thats not the case. It is scarce from an individual point of view, nobody can produce money, but it is not true from a macroeconomic point of view. Central banks can produce any amout of money. From a macroeconomic point of view, the only interesting question is whether the resources, labour, building materials, are best used in this sector. Money is not scarce, but eventually the resources needed, which can be bought with money, are scarce. That is a very big difference. Who doesn't understand this difference, doesn't understand Keynesian theory.

Adam Smith says that an investment that only brings a profit of five percent would not be realised if there are more profitable investments. This is true from a private point of view. However, why a central bank should impede an investment that brings only three percent of the resources needed, for instance labour in case of unemployment, is avalaible? Adam Smith says that this potential should remain unexploited and the central bank should maintain money scarcity. Why should a central bank do that? Actually, any investment able to pay back the credit should be realised.

Another error, perhaps not so relevant in the times of Adam Smith, is his definition of "ordinary interest of money". There is nothing more liquid in this world than money. The ordinary interest of money is therefore determined at a global level and global flows of money have little to do with rentability of the projects themselves. Speculation is driven by the assumed increase of the asset itself, not by its rentability. If the price for houses has increased for instance in Berlin by 41 percent in the last 8 years and the wages has remained the same, the rent could not be raised by 41 percent and investors didn't expect that. They expect that the value of the houses was going to increase.

Besides that, Adam Smith assumes that capital, actually money, flows into the most profitable use. That's not the case. We admit that he sees the problem, "... he had lent it upon good security...', the higher the risk, the higher the interest rates, but he underestimates the problem. Institutional investors are more interested in security than in rentability, see as well type of interests.

The term capital is never really defined and something merely intuitively imagined is a nice example of how a term can narrow the perspective. The wrong ideas about the character of capital in classical, neoclassical theory and in the Austrian school are still dominant until today and is the most fundamental error in economic thinking.

The fundamental error is that at an individual level, there is no difference between capital and money. Both are scarce. There is only a difference in liquidity, in other words, in order to buy something with capital, it must first be converted in money, which is a means of payment for just anything. At a macroeconomic level, money is not non-consumed income of the past, as it is the case of capital. It can be printed.

The first who described the function of capital correctly was Joseph Schumpeter, who is, that's another strange phenomenon, best known for his destructive creation. His concepts of money, actually much more important, was forgotten. That's something that happens very often in economic thinking. From complex theories, only irrelevant concepts survive and the most relevant ones fall into oblivion.

Something similar happens with the Keynesian theory. What Keynes actually refutes is the notion of capital of the classics and neoclassics. (As both made the same mistake, Keynes doesn't distinguish between classic and neoclassics.) In the case of Keynes, the issue is still more strange. The title of the book is 'General Theory about Employment, Interest and Money'. And what is the topic of a book with this title? Interest and money, obviously. In other words, he refutes the classical idea of interest and money, see Keynes.

El impuesto sobre la tierra es un fenómeno curioso también. En Alemania se grava la tierra para generar ingresos, a pesar de que los ingresos son ridículos y se podría igualmente abolir este impuesto. Pero lo que es realmente divertido que es el hecho que los agricultores reciben en parte subvenciones de la comunidad europea para NO cultivar la tierra, dado que la producción agrícola supera la oferta. Sería entonces más fácil abolir ambos.

The affirmation concerning a tax on land is obviously right. The same argument is valid for any kind of tax on fortunes. That's the reason why these kind of taxes are almost irrelevant today. Something like that exists in any country, but the tax revenue derivating from this tax is irrelevant. Besides, it is a fact that this kind of tax is difficult and therefore expensive to collect if justice is respected.

If no money is earned with fortune, it doesn't make a lot of sense to impose a tax on it. Only the real income should be taxed, unless the aim of the tax is not to oblige the owner of this fortune to use it in a profitable way. If someone for instance inherits land but has no clue of agriculture, it can be a good idea to convince him that he is better off, if he sells this land and avoid the taxes.

A land tax assessed according to a general survey and valuation, how equal whatsoever it may be at first, must, in the course of a very moderate period of time, become unequal. To prevent it becoming so would require the continual and painful attention of government to all the variations in the state and produce of every different farm in the country.

Book V, Chapter II

The problem can be easily resolved and is actually resolved by taxing only the income derivating from this fortune. Incomes derivating from fortune are easy to estimate and objective. That's not the case with fortune. The value of a house is difficult to evaluate. In order to know what is is actually worth, one must sell it. However, the rent on this house is the result of the objective market situation.

The next paragraph is only interesting for Germans. In 1776, Adam Smith affirms that the people of Hamburg evaluated themselves their fortunes and the taxes they have to pay based on this evaluation. Yes, the author assumes that Adam Smith took this from a fairy tale.

At Hamburg, every inhabitant is obliged to pay to the state one fourth percent of all that he possesses; and as the wealth of the people of Hamburg consists principally in stock, this tax maybe considered as a tax upon stock. Every man assesses himself, and, in the presence of the magistrate, puts annually into the public coffer a certain sum of money, which he declares upon oath, to be one fourth percent of all that he possesses, but without declaring what it amounts to, or being liable to any examination upon that subject. This tax is generally supposed to be paid with great fidelity. In a small republic, where the people have entire confidence in their magistrates, are convinced of the necessity of the tax for the support of the state, and believe that it will be faithfully applied to that purpose, such conscientious and voluntary payment may sometimes be expected. It is not peculiar to the people of Hamburg.

Book V, Chapter II

It is very plausible that people are more willing to pay taxes and to contribute to the financing of public affairs if they assume that their money is spent in a responsible way. Anything else, for instance if people don't care if their money is wasted, would be strange. The problem is that "small republics" don't exist any more and even in small comunities transparency is nothing natural.

La argumentación en el párrafo que sigue es la misma que tiene David Ricardo y igual de errónea, vea David Ricardo. Si los trabajadores solo ganan lo mínimo vital cualquier impuesto sobre el sueldo lleva a un aumento proporcional del sueldo, porque si no los trabajadores morirían. (Adam Smith es un poco más refinado que David Ricardo, porque por lo menos restringe su afirmación a los sueldos de la categoría más baja. En la teoría de David Ricardo hay solo esta categoría, lo que significa que no hay ningún incentivo para los trabajadores de cualificarse. )

The wages of the inferior classes of work men, I have endeavoured to show in the first book are everywhere necessarily regulated by two different circumstances; the demand for labour, and the ordinary or average price of provisions. The demand for labour, according as it happens to be either increasing stationary or declining; or to require an increasing, stationary, or declining population, regulates the subsistence of the labourer, and determines in what degree it shall be either liberal, moderate, or scanty. The ordinary average price of provisions determines the quantity of money which must be paid to the workman, in order to enable him, one year with another, to purchase this liberal, moderate, or scanty subsistence. While the demand for the 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. Let us suppose, for example, that, in a particular place, the demand for labour and the price of provisions were such as to render ten shillings a-week the ordinary wages of labour; and that a tax of one-fifth, or four shillings in the pound, was imposed upon wages. If the demand for labour and the price of provisions remained the same, it would still be necessary that the labourer should, in that place, earn such a subsistence as could be bought only for ten shillings a-week; so that, after paying the tax, he should have ten shillings a-week free wages.

We are not really interested in the central affirmation of this paragraph. We find the same affirmation by David Ricardo, although David Ricardo expresses it in a more, lets say, crude version. The affirmation is only true in a very special situation, where all the wages are just at subsistence level, in other words, if a tax on wages would be paid by the workers, they would die or at least they would not be able to maintain their families. This leads to an effect and that's the conclusion drawn by David Ricardo, that the capitalist will pay the tax on wages because otherwise he would have only dead and therefore unproductive workers.

From an economic point of view, the affirmation is not worth to be discussed. It is obviously wrong. We all know that wages are different for any kind of work and above subsistence level. The wages to be paid depend on the market situation. That has actually nothing to do with the taxes. Workers and employees bargain about the gross wage. Well it is possible that workers demand more if taxes are high, but if they succeed in increasing the gross wage depends on the market situation.

return to the top of the page ...