1.2.3 effects on taxes

From a formal point of view, Principles of Political Economy and Taxation resembles the Wealth of Nations of Adam Smith. Some chapters even have the same title. However, concerning the content, there are very big differences.

David Ricardo is more Thomas Malthus than Adam Smith. His whole theory is based on the assumption, taken from Thomas Malthus, that the whole national income will always be absorbed by a growing population and wages will always remain at subsistence level.

The second basic assumption it that the profit will decrease in the long run, because, given a certain amount of land, the growing population leads to an increase in the price of food. That has the effect that the "capitalists" have to pay higher wages in order to keep their workmen alive and, therefore, their profits decreases and the rent on land increases.

The accumulation of capital and the decreasing profit in favour of the rent are the central affirmations of David Ricardo.

The whole theory is not compatible with a market economy, see Determination of prices exclusively by the supply side.

Adam Smith analyses taxes in relation to their impact on the allocation of resources, see effects of taxes on allocation. David Ricardo analyses the effects of taxes on the accumulation of capital.

We have already seen that capital is actually money, see interest rates. However, even if we accept the thesis that capital is a productive factor like labour, something we don't do, his theory is wrong. Capital doesn't move alone to the most profitable use. The only classical author well aware of that is Jean-Baptiste Say, see entrepreneur. In this sense, Karl Marx draws the right conclusion from the theory of David Ricardo. His book is called The Capital and not The Capitalists. Capital moves alone, no capitalists in the sense of entrepreneur needed.

The second conclusion of Karl Marx is right as well. If capital is a productive factor like the sunlight which works without any interference of human beings, it can be as well socialised. If the accumulation of capital is not the result of right decisions, work and know how there is no reason why it should belong to someone. If in any case there is no incentive needed in order to be allocated in the most profitable way, if it moves alone to the most profitable way, then it doesn't make any difference if it belongs to private persons or to the society as a whole.

The same thing is true for the theory of Léon Walras and for a lot of concepts we find in modern textbooks. Actually, the entrepreneur doesn't exist in modern textbooks about microeconomics, see mathematic modeling.

In the world of David Ricardo, we have a vast majority that live at the subsistence level and a small group who possess the whole capital. However, this group, as well as the landowners, has no real function, they do nothing. In this case, the capital and the land can be distributed. That would lead to higher income and in the logic of David Ricardo to an increase in the population until they live once again at subsistence level.

If we consider the real world, there are many reasons for private property, a least to a certain degree. Processing information, something absolutely necessary if resources should be allocated in an optimal way is hard work, and this work is only done if there is a recompensation. In other words, even in the case that the classical/neoclassical concept of capital as productive resource were true, what is not the case, see interest rates,

In order to understand his theories about taxation we always have to keep in mind his basic assumptions.

David Ricardo distinguish between the taxation of the land, independently from what this land yields and a taxation of the rent.

We should not confuse rent with profit. Rent is more precise and is the difference between the market price, which is determined by the less efficient producer who can still survive under a given demand, and the actual costs of the respective producer. If the price of potatoes is 2 dollars for a kilo in a town, the farmer far away who can just bring his potatoes to the market for 2 dollars because transportation costs are high, earn nothing. He is the marginal producer. The farmer near the town, who has fewer transportation costs could offer his potatoes for 1.50 dollars, but there is no need to that because the market price is 2 dollars. He gets a rent of 50 cents for each kilo.

This must be understood otherwise the next paragraph is not comprehensible. The logic is correct. A tax on the rent has a very different effect than a tax on fortunes.

A land-tax, levied in proportion to the rent of land, and varying with every variation of rent, is in effect a tax on rent; and as such a tax will not apply to that land which yields no rent, nor to the produce of that capital which is employed on the land with a view to profit merely, and which never pays rent, it will not in any way affect the price of raw produce, but will fall wholly on the landlords. In no respect would such a tax differ from a tax on rent. But if a land-tax be imposed on all cultivated land, however moderate that tax may be, it will be a tax on produce, and will therefore raise the price of produce. If No. 3 be the land last cultivated, although it should pay no rent, it cannot, after the tax, be cultivated, and afford the general rate of profit, unless the price of produce rise to meet the tax. Either capital will be withheld from that employment until the price of corn shall have risen, in consequence of demand, sufficiently to afford the usual profit; or if already employed on such land, it will quit it, to seek a more advantageous employment. The tax cannot be removed to the landlord, for by the supposition he receives no rent. Such a tax may be proportioned to the quality of the land and the abundance of its produce, and then it differs in no respect from tithes; or it may be a fixed tax per acre on all land cultivated, whatever its quality may be.

David Ricardo, On the Principles of Political Economy and Taxation, Land-Tax

He distinguishes between two types of taxation. The first case is a tax on the rent, see above. The other is a tax on the land itself, independently from the tax. A taxation on the rent imposed proportionally to the rent will not be paid by the marginal producer for the simple fact that his rent is zero, and a percentage of zero is zero. It will, therefore, have no impact on the amount produced and on the market price. Nothing will change. The landowners who get rent, however, will pay it, but they will not be able to add to the market price because the marginal producer fixes the market price. If they raise the praise, they will be more expensive than this marginal producer, and therefore, that is not possible.

Tax on the land is different. Any landowner must pay this tax as well and by the marginal producer. This means that the market price will rise (or the amount reduced). If the market price rises, the landowners who get a rent will be able to raise their prices as well with the effect all, they don't pay it. The consumer will pay it. However, the consumers are the workmen of the capitalist and, therefore, the "capitalist" have to pay them higher wages with the result that the profit diminish. It is obvious therefore that David Ricardo is against a taxation of the land.

Most of the land was not cultivated by the landowner itself, but by a tenant, but this doesn't matter. If the landowner tried to get the tax get paid by the tenant, the tenant would withdraw his capital. David Ricardo assumes that the profit of capital is the same in any use. If profits diminish in this sector, the tenant would, therefore, invest his capital elsewhere.

As we already said, the allocation of resources is no problem in the world of David Ricardo. (However, a very big problem in the real world.) David Ricardo is only interested in the impact of taxation on the profits. Tax on the rent, see above, has no impact on the prices and, therefore, it has no impact on the prices of food.

The capitalists only pay a wage at subsistence level, and if the prices for food don't increase, there is no need to pay higher wages and, therefore, there is no impact on the profits.

Tax on the rent that is finally paid by the "capitalists" is a big tragedy for David Ricardo. He is afraid that this will lower the accumulation rate although it is not very clear why a high accumulation rate is needed in his world because the vast majority will always live in the deepest misery.

Secondly, he assumes that if the tax revenue increases at the expense of the profit of capitalists, the government will consume this money instead of accumulating it. Formulated like that, it is wrong. The Ricardian capitalist needs bridges, roads, canals, etc. because otherwise the costs of transportation would be very high and this would lower his profit as well. The assumption that governmental spending is always consumption is wrong, see governmental activities.

[Actually, in the world of David Ricardo we need a lot of police because otherwise the "capitalists" would be hanged on trees. The David Ricardo society is very unstable.]

His last sentence " it would constantly be absorbing so much of the annual produce of the country as to occasion the most extensive scene of misery, famine, and depopulation" is surprising. If the assumption of David Ricardo were true, a greater misery couldn't be imagined.

This may be considered, indeed, as the unavoidable disadvantage attending all taxes received and expended by the State. Every new tax becomes a new charge on production, and raises natural price. A portion of the labour of the country which was before at the disposal of the contributor to the tax, is placed at the disposal of the State, and cannot therefore be employed productively. This portion may become so large, that sufficient surplus may not be left to stimulate the exertions of those who usually augment by their savings the capital of the State. Taxation has happily never yet in any free country been carried so far as instantly from year to year to diminish its capital. Such a state of taxation could not be long endured; or if endured, it would be constantly absorbing so much of the annual produce of the country as to occasion the most extensive scene of misery, famine, and depopulation.

David Ricardo, On the Principles of Political Economy and Taxation, Land-Tax

This paragraph is a nice example of pure ideology. First of all, he assumed that any governmental expenditures is pure consumption. The higher the taxes, the more governmental consumption at charge of private investment. Without infrastructure, the Ricardian capitalist doesn't produce anything. Moreover, it can be argued that the infrastructure, bridges, roads, education, etc. can be provided as well by private entities, but then he should explain how this should work.

What he actually wants to say is, that he doesn't want to pay taxes. It can be argued against taxes, but the argumentation should be more sophisticated.

The argumentation becomes pure ideology when he affirms that taxation leads to less savings. In his world-saving doesn't make any sense. In his world more saving means only that the steady state where due to the lack of land the profits go to the landowner is achieved faster, and the vast majority lives in misery.

Besides that, there is a more fundamental error. He assumes that capital is the condition for investments. That's not true. The condition for investments is money and a project that allows to pay back the credit, wherever this money came from: From not consumed income of the past or generated by the banking system, see interest rates.

In the crazy world of David Ricardo, labour can't be taxed, because the workmen live already on the subsistence level. If their wages were taxed, they would die. Taxes will be paid therefore by the capital and by the land.

The distribution of the national income does not depend, in the world of David Ricardo, from performance but power. The capitalists are not entrepreneurs. They only have the capital. An income distribution based solely on power and not on performance is completely incompatible with a market economy.

The basic problem is the same in the neoclassical theory and in the theory of David Ricardo. Both of them believe that capital is a condition for investments.

[That's why Keynes didn't distinguish between classical and neoclassical theory, see the booklet downloadable from the start page of this website.]

However, concerning labour, there is a difference. Simplifying we can say that all the classical authors assumed that the wage paid to workmen is always at subsistence level. Neoclassical theory assumes that the wages correspond to the marginal revenue. In other words, if the employer earns 10 dollars an hour employing someone, the marginal revenue, after deduction of all other costs, has to be at least 10 dollars, and he will employ that until the marginal revenue corresponds to the wage. That means that wages will increase with higher productivity.

[This is kind of a truism however and is meaningless if it comes to take political decisions. In public debate, it is argued that full employment can be reached by lowering the wages. It can be seen the other way round. Unemployment can be reduced by increasing the productivity, in other words by improving the educational system. Mathematical modeling, widely used in neoclassical theory, has a tendency to ignore all what cannot be modelled mathematically, see mathematical modeling. A simple schema wages = marginal revenue can be modelled, a more complex schema, how to improve productivity, can't be modelled mathematically and is therefore ignored, although this is the interesting question. The simple schema wages = marginal revenue is always valid, all over the world, but meaningless. We don't want to know that in Nigeria and in the United States equation wages = marginal revenue is valid. That's the case, obviously. We want to know why in Nigeria this wage is at or under the subsistence level and in the United States allows a high living standard.]

In this case, the wage is a question of power. In some countries, the wage is a result of bargaining between the trade unions and the employers' association. Trade unions can have two different strategies. They can demand high wages for few people, in this case only highly productive sectors of the economy can pay them, or low wages for a maximum of people.

En cuanto al impuesto sobre el sueldo se refiere su argumentación se asemeja a la argumentación sobre la tierra. No le interesa el efecto alocativo de un impuesto, sino el efecto sobre el provecho. La acumulación del capital es el único aspecto que le interesa a pesar de que esta acumulación solo lleva un número más grande de personas que viven en la miseria.

Taxes on wages will raise wages, and therefore will diminish the rate of the profits of stock. We have already seen that a tax on necessaries will raise their prices, and will be followed by a rise of wages. The only difference between a tax on necessaries, and a tax on wages is, that the former will necessarily be accompanied by a rise in the price of necessaries, but the latter will not; towards a tax on wages, consequently, neither the stock-holder, the landlord, nor any other class but the employers of labour will contribute. A tax on wages is wholly a tax on profits, a tax on necessaries is partly a tax on profits, and partly a tax on rich consumers. The ultimate effects which will result from such taxes then, are precisely the same as those which result from a direct tax on profits.

David Ricardo, On the Principles of Political Economy and Taxation, Taxes on wages

The logic is always the same and only comprehensible if one have the basic assumptions of David Ricardo in mind. If the workmen get a wage at the subsistence level and if a tax is imposed on this wage, the employer has to pay higher wages so that the wage of workmen remains the same after having paid the tax. Otherwise, they would die. There is, therefore, no difference, in the world of David Ricardo, between taxes on food and taxes on wages. In the end, the "capitalist" will pay it. (The only difference is that rich consumers, who don't employe workmen, will pay this tax as well.)

We put aside the basic errors of David Ricardo and discuss his theory under his assumption, but even under his assumptions, the logic is wrong. If wages are equal everywhere, independently from the qualification of the work, and always at subsistence level, the capitalist can as well pass the taxes to the prices. In this case, the "rich consumer", or the whole society, would pay part of taxes and not only the employer.

If we consider the reality, we can see that wages are not equal at all, and employees pay taxes, things become more complicated. Everybody knows that employees and workmen pay taxes and that the employer will not raise the wages, therefore. The theory of David Ricardo has nothing to do with reality

Employees and workers get paid depending on the marginal revenue and in industrialised countries, this marginal revenue is much higher than the subsistence level.

Qualified labour is scarce, much scarcer than capital that is actually money, and must be paid much more than the subsistence level, otherwise the employer wouldn't find people willing to work for him.

At the other side, the employees and workmen can't pass the taxes to the employer because by doing so wages would be higher than the marginal revenue and the employers would reduce their staff.

return to the top of the page ...

1.2.3 effects on taxes

The effect of taxes on profits