1.1.9 effects of taxes on allocation

Most of the issues that are in the centre of public debate today are already discussed in Wealth of Nations. Due to the fact that the tax system was simple in the time of Adam Smith, the discussion is simple as well. Nevertheless, the central aspects to be taken into account are already considered.

1) effects on allocation
2) effects on distribution
3) efficiency of tax collection
4) aims pursued

We can distinguish three different types of taxes. The first type is imposed on the consumption of something. The most famous tax of this type is the value added tax. Of a similar kind are the taxes on alcohol, petrol, customer duties etc..

The second type are the taxes on profits of any kind: income of salaried work, income of self-employment, rent revenues, income from assets etc.

The third type are the taxes on the fortune, independently if this fortune yields any profit. Example of taxes of this kind are taxes on land, wealth, but as well the inheritance tax.

All of these different type of taxes have different effects on allocation and distribution. The costs of collecting these taxes are different and the aims pursued are different. We are not discuss this topic here in detail. However, few remarks are enough to see that Adam Smith discusses the topic under very special assumptions.

The value added tax is generally considered problematic concerning the just distribution, because poor people spend, in relation to their income, more on consumption than rich people and pay therefore, in relation to their income, more taxes. This contradicts the generally accepted idea, that richer people have to pay, in proportion to their income, more taxes.

At least in theory, the value added tax reduces consumption and increases. Therefore, we tend to save more. This can be useful in case of full employment. The increase in prices due to the value added tax will increase the tax revenue, allowing the government to spend more money on infrastructure. At the other side, the reduction of consumption will lead to a reallocation of productive resources. More capital goods will be produced and less consumption goods. In case of unemployment due to a lack of demand, the more normal situation, the value added tax is less useful.

Concerning taxes on specific goods, for instance, on alcohol, tobacco, petrol it is argued that they serve specific goal. Preventing people from drinking too much, promoting public health in the case of tobacco or environmental protection. In most cases, however, these taxes serve most of all to increase the tax revenue.

An advantage of the value-added tax is that it is less perceptible. The government is confronted with less resistance if it increases the value added tax than if it increases the income tax.

The other argument in favour of the added value tax is less convincing. It is argued that the value added tax can be collected at low costs. This is only true if we consider the public administration. It is not true at all if we consider the burden imposed on the private sector.

In the centre of the public debate is, in general, the income tax. The income tax allows to take into account the personal situation, whether there are kids or not, if someone lives in the household who needs help, if people live together or are married etc.

Concerning the effect on distribution, we have a very wide range of opinions. However, one thing is pretty clear. If the government pays social welfare to people who don't earn enough to live, it doesn't make any sense to tax income below the level where this social welfare is paid, although this is what happens in many countries, for instance in Germany.

There are only few taxes on fortune. Taxes on fortune to be paid no matter whether this fortune yields any income would reduce the fortune if it actually yields no income. There are very few taxes of this type and the revenue deriving from this kind of taxes, for instance, a tax on land, it almost irrelevant (at least in industrialised countries.) A tax on fortunes is always a double taxation because fortune is normally the result of already taxed income. The most important case of this kind are owner-occupied homes and apartments. Fortunes of this type is part old-age provisions, and it, therefore, doesn't make any sense to tax them if at the other side private provision for one's retirement is subsidised by the government. (As it is the case in most industrialised countries.)

To a different degree depending on the type of taxes, taxation changes the allocation of resources. Sometimes it is even the goal of taxation to change the allocation. (A tax on fuel for instance aims to reduce the consumption of fuel.) Taxation always means that resources and power are reallocated by the government. The use of these resources is not steered by prices as in a market economy, see for instance perfect market, but by somehow arbitrary and uncontrolled governmental activities.

What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can in his local situation judge much better than any statesman or lawgiver can do for him. The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.

Book IV, chapter II

An effect of this kind has as well customer duties. If a tax is imposed on commodities which compete with national commodities, the national producers get an advantage at the expense of the national consumer who pays more than what is needed.

To give the monopoly of the home market to the produce of domestic industry, in any particular art or manufacture, is in some measure to direct private people in what manner they ought to employ their capitals, and must in almost all cases be either a useless or a hurtful regulation. If the produce of domestic can be brought there as cheap as that of foreign industry, the regulation is evidently useless. If it cannot, it must generally be hurtful. It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbours, and to purchase with a part of its produce, or, what is the same thing, with the price of a part of it, whatever else they have occasion for.

Book IV, chapter II

The argument is as simple as convincing. If specialisation makes sense at a national level, it makes sense as well as an international level.

If we look at a country as a whole, a customer duty is a mere redistribution from the consumers, who pay more, to the producers, who earn more.

However, this argument is not always true. If the EXPORTING country fully pays the customs duties, that happens for instance if the exporting country, mostly underdeveloped countries, depends on this export, they lower their prices, so that the price doesn't increase in the importing country. In this case, the consumer loses nothing, but the government increases its revenue.

[Obviously, that only works if the exporting country is not able to increase its customer duties.]

An example of this kind of customer duties, with a heavy negative impact on the exporting countries, are the customer duties on coffee and cacao. Three millions tons of cacao were exported every year. However, the cacao beans are not processed in the Ivory Coast or Ghana, the main producers of Cacao, these two countries only produce 40 percent of the worldwide production, but in Europe or other northern countries, because only the raw cacao beans can be imported with no or very low customer duties. If they are processed to cocoa powder, chocolate, etc. they are taxed, depending on the processing level, with 30 or 60 per cent. That way it is impossible for the Ivory Coast or Ghana to export choclate products.

The effect is the protection of the national producers at a charge of the national consumers who could buy chocolate and lower prices if the it were possible to import chocolate at a higher processing level.

However, that is not the real problem. Consumers in industrialised countries can afford that. However, it has a devastating effect on the economy of the exporting countries. Only 1.5 per cent of the profits goes to the Ivory Coast and Ghana.

At the time, there is big public discussion about child labour and slave like working conditions in these countries. Both problems can be resolved easily by abolishing the customer duties on chocolate products. If these countries can process their Cacao and export finished products, they can earn enough money to send their children to school and to pay decent wages.

Nevertheless, this assumption is wrong: "To give the monopoly of the home market to the produce of domestic industry, in any particular art or manufacture, is in some measure to direct private people in what manner they ought to employ their capitals, and must in almost all cases be either a useless or a hurtful regulation."

He mixes two things that have nothing to do with each other: "The tailor does not attempt to make his own shoes, but buys them off the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor."

The first argument is wrong; the second argument is true. Adam Smith in general uses capital and money as synonyms, see interest rates. However, in general, he uses the word capital more in the meaning of money for investment purposes. If capital becomes idle because products formerly produced inside the country are no imported, there is no guarantee that the idle "capital" can be used elsewhere. It is actually implausible. If there are unused resources, they could have already been activated with money, and if there are none, they can't be activated with "capital". (As we already said, the confusion between capital and money leads to a cascade of error in thinking, see interest rates.)

If the chocolate industry goes bankrupt because the customer duties on chocolate products were eliminated, they can't reallocate their capital. [Something Adam Smith himself acknowledged in Wealth of Nations. Therefore, he pledges for slow diminution of customer taxes and not for a sudden abolishing.] We will return to the topic when talking about comparative costs.

The second argument that the tailor does not attempt to make his own shoes is more or less true, even in reality we very often see that people do something themselves that someone else can do more efficiently. A lot of people for instance repair their cars themselves. Only in the case, that they can do something more profitable in the time they repair their car, they will bring it to garage. If they can earn 20 dollars in the hour needed to repair their car and would pay 15 dollars to get it repaired, they will let it get repaired by the garage. Otherwise not. If they have nothing to do, they will repair the car themselves. (If they can repair it, obviously.)

The same logic applies to international trade. It is well possible that big fishing fleets are more efficient than a single fisherman on his boat. However, if he can't make any other use of his time, he will continue fishing.

We will not try to prove the following thesis, but it is very plausible. Innovative economies who can generate jobs with innovative jobs will be more induced to reduce customer duties than economies who are less innovative. That's actually obvious. If people working, for instance in the textile industry, find better-paid jobs in the electrical industry, and it becomes, therefore, more and harder to produce textiles inside the country, there is little need for customer duties. There is nothing left that should be protected.

In some special cases, customer duties can as well have a devastating effect inside the country. In the 80th computers were charged with heavy customer duties in France. The aim was to protect the French company Bull; the effect was devastating. Without computers, it 's hard to study informatics and France lost the connection to new technologies. Same thing happens nowadays, we are still in 2015, with Cuba. Actually, it wouldn't be a big problem to send second-hand computers to Cuba if one buys 10 of them it is possible to get them for 500 euros. However, importing them to Cuba is impossible, because they would be charged as new computers. Without computers the Cuban society will lose the connection to the rest of the world and even if the regime falls in the next year, it will take a while until the society closes this gap.

At the other side, there are some special situations where customer duties o subvention, actually the same thing, both of them are paid by the society as a whole, can make sense. Some industries require huge investments, for instance, aircraft construction. If there is no protection at the beginning, a newcomer can't compete with existing companies, although in the long run the investments are profitable. This was, for instance, the case of Airbus Industries, which was highly subsidised by several European countries at the beginning. (We will not discuss here the complaints of Boeing at the WTO etc.)

If a government supports with customer duties, subventions, non-tariff barriers (the import of a commodity is prohibited with the argument that it doesn't comply with certain regulations) the production of a commodity that can be produced more efficiently in foreign countries the national economy is less competitive. If Germany, for instance, would produce textiles itself, they would be much more expensive. This would lead to higher cost of living and in the long run to higher wages. Germany would be less competitive in comparison to a country that imports textiles. This is not a big problem if we consider only textiles, but it becomes a problem if we consider a broader range of commodities.

What is actually stunning is the fact that there is always a big public discussion about immigration. The argument is that foreigners take away jobs of natives. This is strange because nobody complains if he can buy a t-shirt produced in Bangladesh for 5 euros which would have cost 15 euros when produced at home. In both cases, foreign workers compete with native workers. Those who are against immigration should be against the import of cheap products as well. If immigrants "stole" the jobs of native workers, they do that as well if they import their products. However, everybody is happy if he can buy textiles, food, electrical appliances, toys etc. at low prices.

The author has no intention to justify the exploitation of countries like Bangladesh, Thailand, Burma etc. The only thing he wants to say is that from a purely economic point of view the protests against immigration are illogical if it is argued with the local labour market. Immigration and importation of products have the same effect.

The discussion is more complex, and we have no intention to discuss it here. Europe has to change its policy regarding technological cooperation, abolish the customer duties, most of all upon chocolate, coffee, textiles and invest more in training of immigrants helping them to set up companies in their countries of origin. If there is a greater supply in Africa, Africa becomes an attractive market. If they don't produce anything, the can't buy anything from Europe.

Wealth of Nations is full of contradictions. Very often Adam Smith is on the right path but loses it again. In the paragraph below Adam Smith described, although unconsciously, a big truth. Only in the case that capital, the result of non-consumed income of the past that has been invested, is reconverted to its most liquid form, money, it can be invested again. From that he could have deduced that money is needed for investments and not capital and money can be printed. There is no need relinquish consumption in order to get it, see interest rates.

Besides that, he mentions as well that capital can be destroyed. If he had thought a little bit more about the issue, he would have realised that in a market economy the destruction of capital is something very normal. If there is a change in the underlying economic structures, because new competitors appear, because the preferences changed, because some raw materials have to be substituted by others capital will be destroyed. If he had thought about it a little bit, he would had realised that capital, not consumed income of the past, can not be the condition of investments. If this were the case, after a war or an earthquake, to take an extreme example, an economy would start at point zero again. That is obviously not the case. After complete destruction of the economies, very quickly, they reach the level of welfare that corresponds to the know-how of the society.

We will address this issue, the fact that investments are financed with money and not with capital in the chapter about Joseph Schumpeter.

The undertaker of a great manufacture, who, by the home markets being suddenly laid open to the competition of foreigners, should be obliged to abandon his trade, would no doubt suffer very considerably. That part of his capital which had usually been employed in purchasing materials, and in paying his workmen, might, without much difficulty, perhaps, find another employment; but that part of it which was fixed in workhouses, and in the instruments of trade, could scarce be disposed of without considerable loss. The equitable regard, therefore, to his interest, requires that changes of this kind should never be introduced suddenly, but slowly, gradually, and after a very long warning. The legislature, were it possible that its deliberations could be always directed, not by the clamorous importunity of partial interests, but by an extensive view of the general good, ought, upon this very account, perhaps, to be particularly careful, neither to establish any new monopolies of this kind, nor to extend further those which are already established. Every such regulation introduces some degree of real disorder into the constitution of the state, which it will be difficult afterwards to cure without occasioning another disorder.

Book IV, Chapter II

That is really a remarkable sentence: "That part of his capital which had usually been employed in purchasing materials, and in paying his workmen, might, without much difficulty, perhaps, find another employment; but that part of it which was fixed in workhouses, and in the instruments of trade, could scarce be disposed of without considerable loss."

Adam Smith states clearly that "capital" can be invested only in the most liquid form: money. What he doesn't explain is the difference between a 100 dollar bill as a result of prior saving, investing and disinvestment and a 100 dollar bill hot of the press of the central banks. It is to presume that an investor doesn't care where the 100 dollar bill comes from. The only thing he cares about at the moment he takes a loss is the question whether he will be able to pay it back and in both cases, he has to pay it back.

There is only one difference between these two 100 dollar bills. If he will not be able to pay it back, there is no increase in the amount of money circulating, while in the second case the amount of money will be increased. In the first case, someone lost money, and this money is now in the hands of someone else. In the second situation, the money produced when the loan was granted will not be destroyed afterward when the loan is paid back. See interest rates.

In this little paragraph, he contradicts most of the assumptions made before. If capital for investment purposes is actually money and not capital, it is not a productive factor. Therefore the classical theory of the three productive factors capital, labour and land is wrong.

If capital for investment purposes is actually money, it can be printed. There is no effort or sacrifice needed to produce it, and if there is no effort or sacrifice needed to produce it, it is not necessary for a recompensation. Therefore, the interest rates have a function, see interest rates, but they don't have the same function that have other prices like wages, rent on land or prices on commodities. In other words, the interest rate is not a price in the sense of a market economy.

Adam Smith assumes that economic growth depends on the amount of capital. In this logic, the more people save, the bigger the growth. However, if capital is actually money, it can be produced in any amount and, therefore, economic growth depends on something else. .

In every textbook about microeconomics and macroeconomics, we see a little graphic showing that savings increases if the interest rates rise and investment decreases for the same reason. Where savings equals investment, we have the equilibrium interest rates. This is graphic is meant as an illustration of the capital market. The basic assumption of this graphic model is that capital is needed for investment and that capital can only be obtained if there is an incentive to save, the interest rates. If this is not the case, and actually it is not the case, the graphic is nonsense. Something like a capital market simply doesn't exist. What exists is a money market, and this money market works in completely different way.

The confusion between capital and money and attributing to capital functions that it doesn't have is one of the most typical errors in economic thinking until nowadays. This basic errors leads to a cascade of other errors, see interest rates. To get a quick overview, you can download as well the booklet about Keynes downloadable from the start page of this website.

The sentence "That part of his capital which had usually been employed in purchasing materials, and in paying his workmen, might, without much difficulty, perhaps, find another employment" is wrong as well for another reason. Something very easy to understand.

The reader can ask his friends what they would do if they win 10 million dollars in the lottery. Most people will respond that they would buy something they like, a big car, a ship, a villa etc..That way they will spend let's say 5 million dollars. However, what will they do with the remaining 5 million? 99 percent of the people would say that the would bring to the bank or another institutional investor (pensions funds, insurance companies, etc.) They hope, nobody knows why, that institutional investors can use their money in a profitable way and can, therefore, pay interest rates. The little survey will show the reader that very few people are actually able to invest money themselves in real projects. Actually, the only real thing people invest normally during their lifetime is in houses. Entrepreneurs, people who can invest in real projects or start companies, are a very rare species.

That people find "without much difficulty" another employment for their capital is completely wrong. However, even an entrepreneur is in general not able to invest in another company. For investing in something, a detailed knowledge of the branch is needed. At least, if the decision to invest is based on information and more than gambling.

There are very few people with innovative ideas and still less who are actually able to run a company. Most people trust in institutional investors and hope that they will find the profitable investments they can't find themselves. This hope lacks any foundation. We will discuss this issue again in the chapter about Keynes. Keynesian theory addresses insecurity. What is no problem at all for Adam Smith, although it is a very real problem in the real world, is the main problem in Keynesian theory.

If we abstract from insecurity, as the classical/neoclassical theory and all the line of thinking based on their thinking do, we abstract from the central problem that a market economy resolves best. A market economy can't eliminate insecurity, nobody can do that, but it is the best system to correct errors. However, even a market economy can reach to a point where insecurity leads to stagnation. That what Keynesian theory is about.

In the next paragraph, Adam Smith once again loses the right path and falls back to the initial erroneous idea that capital it the condition for investments.

The general industry of the society can never exceed what the capital of the society can employ. As the number of workmen that can be kept in employment by any particular person must bear a certain proportion to his capital, so the number of those that can be continually employed by all the members of a great society must bear a certain proportion to the whole capital of the society, and never can exceed that proportion. No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain.

Book IV, Chapter II

In this paragraph, he falls back to the misleading concept of capital as a condition for employment. Capital, not consumed income of the past, is needed to pay the workers.

This would be true if the wages would be paid in corn or things like that. It is obvious that a certain part of the annually produced corn must be used to pay the workers, and this corn must have been saved previously.

This is kind of Robinson Crusoe economy. Robinson Crusoe can only invest, produce capital goods like a fishing rod, a boat, a bow if he reduces production of consumption goods. He can catch fishes with his hands or produce a fishing net in order to catch more fishes in the future. He must reduce his consumption of fishes for some days in order to get the fishing net allowing him to catch more fishes.

The Robinson Crusoe example is very often used to illustrate that capital is the result of a previous sacrifice and that this sacrifice is only done if there is a recompensation in the future. More fishes to eat in this case.

The problem is that even in this Robinson Crusoe world the logic is wrong. The Robinson Crusoe problem is about the use of his workforce. If he fishes with his hands, he gets his fishes quickly, but only a few. If he makes a fishing net, he gets them later, but more of them. The question is actually when he gets paid. After an hour or after a few days.

To stick with the example of Adam Smith. Obviously, the workmen have to work some hours to satisfy the basic needs. (If Robin Crusoe needs all his forces to catch enough fishes to survive, he has no option, that's obvious. In this case, he can't produce capital goods.) Concerning the rest of their working time, they can agree with their employee to get paid afterwards when the result of their work is sold and materialised in money. (What is, by the way, the proper way of payment. Workers get paid at the end of the month, not at the beginning.) There is no need for capital.

If the workers get paid, with money, they get a claim on the part of the productive potential. If this part have been produced before, as in the case of corn, at the moment they buy it, in the case of services like a haircut, or in the future is an entirely different story. The idea of Adam Smith is that "capital" contains a value that can be changed at any time in a commodity with the same value. That's not true. The actual value of "capital" depends on the productive potential and not on the commodities already produced.

How many people can actually be employed doesn't depend on the non-consumed production of the past, but in the production of the future. No matter how many "capital" the "capitalists" have, if they don't expect to be able to produce something that actually can be sold, they are not going to employ anyone. However, if they expect to produce something that can be sold, they can finance the production with money. For a more detailed discussion see interest rates.

The money market can actually a limitation of the labour market and employment, but not the way Adam Smith imagined. The interest rates are fixed on the money market, and this market depends completely on speculations, see Keynes. The interest rates arbitrarily fixed there can impede new investments and full employment. Real investments compete with the interest rates fixed arbitrarily on the money market. They can, therefore, impede investments before full employment is reached. In other words and quoting Keynes, the whole economy depends on a casino.

Those who don't understand the crucial difference between capital in the meaning of the classics and money are referred to Joseph Schumpeter. Schumpeter as well as Adam Smith assumes that full-employment is is always given. Therefore, he believes that money has only an impact on the allocation of resources, but in any case, all resources are used. It is, therefore, a much simpler theory than the Keynesian theory, but it helps to understand the basic problem.

In the next paragraph, he addresses the issue that in the long run it can be useful to protect a certain sector of the industry from foreign competition if this sector becomes competitive in the long run. (See the example with Airbus industries mentioned before.) This aspect can actually be relevant. However, once again, Adam Smith sticks to his concept of capital and, therefore, his conclusions are wrong.

By means of such regulations, indeed, a particular manufacture may sometimes be acquired sooner than it could have been otherwise, and after a certain time may be made at home as cheap, or cheaper, than in the foreign country. But though the industry of the society may be thus carried with advantage into a particular channel sooner than it could have been otherwise, it will by no means follow that the sum-total, either of its industry, or of its revenue, can ever be augmented by any such regulation. The industry of the society can augment only in proportion as its capital augments, and its capital can augment only in proportion to what can be gradually saved out of its revenue. But the immediate effect of every such regulation is to diminish its revenue; and what diminishes its revenue is certainly not very likely to augment its capital faster than it would have augmented of its own accord, had both capital and industry been left to find out their natural employments.

Book IV, Chapter II

In one sentence, we have the whole tragedy of economic thinking: "The industry of the society can augment only in proportion as its capital augments, and its capital can augment only in proportion to what can be gradually saved out of its revenue." Until today, we can read on a daily basis that capital, defined as non-consumed income of the past, is the condition for investments.

The argumentation works like this: If the government protects by customer duties, taxes, subventions, non-tariff barriers, etc. a certain sector, as in the case of Airbus Industries, it is well possible that this industry grows faster as it would do without protection. However, this faster growth will be paid by the consumers, in case of customer duties, or by the taxpayer, in case of a subvention. That will lead, following this argumentation, to a decrease in saving in other sectors and given that investments, in the world of Adam Smith, depend on capital, not consumed income of the past, other sectors of the economy would grow more slowly than it would have been the case without protection.

It is right that the protection of one sector of the economy has a negative impact on other sectors of the economy. However, the argumentation is completely wrong.

There are two ways protection of one sector affects the other sectors negatively. The first way is that protection leads to an increase of prices of primary products or makes it difficult to establish companies based on these primary products. A heavy tax on computers, for instance, makes it difficult to offer internet services because most companies depend on their local markets before they can expand to foreign countries.

Besides that, resources were attracted by the protected areas that would be used without protection in other sectors of the economy. At the time, the engineers of AirBus Industries developed new airplanes, they could have done something else.

The argument forwarded by Adam Smith is less convincing because capital is no productive factor. If there are productive resources, they can be activated with money. There is no capital in the meaning of not consumed income of the past needed.

Certain industries are protected because they are considered strategically relevant, although it is not very clear, why they are considered strategically relevant. Airbus Industries, for instance, was found to be strategically relevant. The dependence of Europe on American aircraft industry was regarded as a risk. However, it is unclear how Boeing can abuse of his power if they must sell their airplanes. Perhaps it would have been better to invest the money in research in the field of molecular genetics or in generating energy from seaweed.

Some years ago, the search engine market was considered strategically relevant, and there was a big discussion whether the European Commission should subsidise the development of Google like a search engine named quaero. This is strange as well. Google depends on the content and without content, Google doesn't make any money because only in the case that there are millions of websites, a search engine is needed. A much better idea would have been to subsidise content. The money spent, 240 millions euros, in quaero could have

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