«Abstract Commentary and political rhetoric on taxes in the United States have long included appeals to Smith’ (1776) classical logic of bene.t ...»
Revisiting the Classical View of Bene…ts-Based Taxation
February 11, 2014
Commentary and political rhetoric on taxes in the United States have long included appeals
to Smith’ (1776) "classical" logic of bene…t based taxation in which an individual’ bene…t from
the state is tied to his or her income-earning ability. Modern optimal tax theory, in contrast,
largely ignores the principle of bene…t based taxation. This paper shows that the classical logic of bene…t based taxation can be readily incorporated into the formal structure of modern theory.
Moreover, by applying Lindahl’ well-known methods, optimal policy according to that principle s can be characterized analytically as depending on a few potentially estimable statistics. An objective for policy that gives weight to both this principle and the familiar utilitarian criterion can explain a variety of features of existing policy that are di¢ cult to reconcile in standard theory, consistent with its apparent role in real-world normative reasoning over tax design.
Introduction These [urban] centers and their wealthy residents have cause for satisfaction and thanksgiving that their incomes are so bountiful and that the country has provided them with such great opportunities, rather than occasion for criticising the requirement of a moderate contribution to the nation which has rendered such incomes possible.
Roy Blakey, American Economic Review, 1913 In February, 1913, the Sixteenth Amendment to the U.S. Constitution was passed, allowing for the direct taxation of incomes. One month later, the nascent American Economic Review included a paper by Roy Blakey (1913), a noted tax expert and University of Minnesota professor, that gave the preceding argument for the propriety of taxing large (mainly urban) incomes.
In 1935, U.S. President Franklin Delano Roosevelt sought to substantially increase the progres- sivity of taxes. He argued as follows.
"With the enactment of the Income Tax Law of 1913, the Federal Government began to apply e¤ectively the widely accepted principle that taxes should be levied in proportion to ability to pay and in proportion to the bene…ts received. Income was wisely chosen as the measure of bene…ts and of ability to pay. This was, and still is, a wholesome guide for national policy. It should be retained as the governing principle of Federal taxation....
Harvard Business School and NBER, firstname.lastname@example.org. Thanks to Rafael Di Tella, Benjamin B. Lockwood, Greg Mankiw, David Moss, Andreas Peichl, and Glen Weyl for valuable discussions.
Modern tax theorists will …nd the normative principle underlying these quotations both familiar and strange. All three refer to the logic of "bene…t based taxation," under which people ought to pay taxes that depend on how much they bene…t from the activities of the state. All three quotes also refer to the logic of "ability based taxation," under which people ought to pay taxes that depend on how hard it is for them to earn income. Introductory public …nance textbooks describe these two ideas as the classic principles of optimal tax design. But they are usually considered alternatives, not complements. To modern tax theorists working in the tradition of James Mirrlees (1971), stranger still is the use of these principles at all, as modern tax theory largely ignores or dismisses them in favor of an approach emphasizing social welfare maximization.
Two hundred years ago, however, the underlying normative principle would have been recognized
immediately as Adam Smith’ (1776) …rst maxim of taxation:1
s "The subjects of every state ought to contribute toward the support of the government, as near as possible, in proportion to their respective abilities; that is in proportion to the revenue which they respectively enjoy under the protection of the state."
Like those quoted above, Smith argues that one’ income– function of one’ ability– a measure s a s is of one’ bene…t from the state. Because he supports bene…t based taxation more generally, Smith s believes ability is therefore an appropriate basis for taxation. Simply put, Smith endorses bene…t-as-ability based taxation. Richard Musgrave (1959) labeled this logic the "classical" view of bene…t based taxation, a label I adopt in this paper.
This classical view of bene…t based taxation was highly in‡uential in the late 18th and early 19th centuries but waned as John Stuart Mill’ (1871) purely ability based reasoning gained favor and the s canonical contributions of Erik Lindahl (1919) shifted the focus of bene…t based tax research. The idea of bene…t-as-ability was not further explored, while bene…t based and ability based reasoning were developed as separate ideas.2 When ability based reasoning was absorbed into the Mirrleesian approach, bene…t based taxation was largely left behind.
In its place, modern tax theory seeks to maximize a social welfare function that depends on the sum, or at times a more subtle aggregation, of individual utilities.3 As one striking example, the authoritative review of modern tax theory entitled the Mirrlees Review (2011) makes no reference 1 As the remarkable surveys by Edwin Seligman (1908) and Richard Musgrave (1959) make clear, bene…t based reasoning was a prominent, at times leading, approach among tax theorists through the 19th century. The logic evolved over time. Early on, in Hobbes, Hume, and Rousseau among others, the primary bene…t taxpayers received from the state was protection, with the state acting as something like an insurer of private property. Smith (1776) extended the notion of the proper role of the state and formulated the broader view of bene…t based taxation that is the focus of this paper.
2 See the discussion in Musgrave (1959) 3 To be clear, modern theory in principle imposes only Pareto e¢ ciency. See the discussion toward the end of the Introduction for more on this.
2 to Lindahl’ (1919) canonical development of a bene…t based theory, or to any of the relatively s few more recent re…nements of it. Anthony Atkinson and Joseph Stiglitz’ (1980) classic text and s Louis Kaplow’ (2008) invaluable modern treatise each devote only a few pages among hundreds to s bene…t based taxation, the latter largely to point out its weaknesses (as discussed below). Neither Bernard Salanié (2011), in his essential textbook on the economics of taxation, nor Robin Boadway (2012), in his excellent survey of optimal tax theory’ implications for policy, mentions Lindahl or s 4 bene…t based taxes.
This paper’ contribution is to attempt a resuscitation of the classical view of bene…t based s taxation by showing how it can be formalized in the modern framework of optimal tax theory.
Perhaps surprisingly, Smith’ idea …ts easily into the Mirrleesian approach once one makes a simple– s and arguably needed– change to the standard setup: that is, allowing individual income-earning ability to be a function of both natural talent and the activities of the state.
The powerful Lindahl apparatus can then be applied to characterize …rst-best policy, according to this principle, in terms of simple and potentially observable elasticity parameters. In particular, this approach yields straightforward conditions determining the progressivity of optimal average tax rates as well as this model’ version of the Samuelson rule for the optimal extent of public goods s spending. These conditions reduce to simple, intuitive relationships if we assume that the ability production function takes certain forms. Moreover, assuming those same forms, we …nd the remarkable result that optimal bene…t-as-ability based taxation is equivalent to Mill’ preferred "equal s sacri…ce" taxation, a possibility hinted at informally nearly forty years ago by Martin Feldstein (1976).
This paper then provides a numerical characterization of second-best policy according to the classical bene…ts-based view and shows how di¤erent assumptions about the interaction of the activities of the state and natural talent a¤ect the progressivity of constrained optimal policy. As with the analysis of the …rst-best policy, it turns out that Smith’ idea can be easily analyzed s as part of the constrained optimization familiar from Mirrleesian theory. The key is that, unlike bene…t based theories in which individuals di¤er along two dimensions (ability and preferences for public goods), in Smith’ framework a single dimesion of heterogeneity (ability) is preserved, so the s standard second-best analysis applies. One remaining complication is that the classical bene…tsbased view does not provide a ranking of allocations other than the …rst-best. To address this limitation, I specify a simple loss function that allows the planner to choose the allocation, from the set of incentive compatible allocations, that deviates least from the …rst-best.
Why go to the trouble of attempting such a resuscitation?
If one takes a positive approach to specifying the objective of optimal taxation, the rhetoric of Presidents Roosevelt and Obama– and similar statements provided in the next section– suggest that the classical view of bene…t based taxation ought to be included in the criteria used to judge policy– at least with regard to the United States. While conventional optimal tax analysis imposes an objective function for policy based on the modeler’ normative reasoning, recent work has pursued s the idea of basing that objective on evidence of the normative priorities that prevail in society.5 An important feature of this "positive optimal tax theory" is its inclusion of multiple normative criteria, as a wide range of evidence has shown that most persons base their moral judgments on 4 While bene…t based reasoning has fallen out of favor as a basis for optimal taxation, it is worth noting that it continues to occupy a prominent but narrow role in tax theory more broadly. [elaborate, including mention of isolated instances of endogenous ability in a Lindahl setting] 5 See Weinzierl (2013a) and Saez and Stantcheva (2013); also see Zelenak (20xy) for a di¤erent, legal theory, perspective. Such a positive optimal tax theory di¤ers from a purely positive theory of taxation, where the political process and self-interest of voters play central roles. Positive optimal tax theory retains the conventional theory’s focus on an objective that re‡ ects the moral reasoning of an impartial observer.
3 more than one principle.6 The second contribution of this paper is, therefore, to demonstrate the quantitative explanatory power of an optimal tax model with an objective function that gives weight to both the familiar utilitarian principle and the classical view of bene…t based taxation. To implement that analysis, I follow the technique introduced in Weinzierl (2012) to combine the normative criteria into a social loss function. Social loss is a weighted sum of losses according to the included criteria, where I use the loss function from the previous analysis for the classical bene…t based principle and the natural form of a loss function according to the utilitarian criterion. I show that a mixed objective such as this can help to explain features of existing policy that are di¢ cult to reconcile with a conventional objective, including resistance to most forms of tagging, a rejection of rank reversals in the …rst best allocation, and empirically realistic levels of redistribution and progressivity. Though novel, these results should not be surprising given the prominent role the classical bene…t based view appears to play in prevailing moral reasoning over tax policy.
It is important to clarify that this paper is not intended to defend classical bene…t based taxation as a normative principle. Other principles, including conventional social welfare maximization, may well be preferable from the perspective of moral and political philosophy. Instead, this paper is intended to capture the view of bene…t based taxation that arose in early sophisticated thinking about optimal taxation and that has retained a prominent role in public reasoning over taxes despite the strong criticisms of more recent tax theorists.
Nevertheless, an important discipline for positive optimal tax theory may be that the principles it identi…es as holding sway can be defended as "reasonable." To that end, toward the end of the paper I review several of the most important modern critiques of bene…t based reasoning and how the classical logic elaborated in this paper was designed to, at least in part, overcome them. As part of this, I note that this classical view of bene…t based taxes is not "libertarian" in the sense of a minimal state. The state under Smith’ classical view of bene…t based taxation may be quite s expansive.7 The moral intuition for Smith’ view does not depend on the state being small; it s merely depends on the costs of the state’ activities being assigned as if a market for them could s exist and, thereby, tie individuals’payments to the bene…ts they obtain from those activities.
Similarly, it is important to be clear that the mixed normative objective utilized in this paper is not in con‡ with the most general forms of modern optimal tax theory. As has been made clear ict in work by Stiglitz (1987) and Iván Werning (2007), among others, Mirrleesian optimal tax theory imposes only the requirement of Pareto e¢ ciency on the set of feasible and incentive compatible allocations. The objectives I consider satisfy Pareto e¢ ciency as well, so in principle they could be modeled in alternative ways that are closer– formal terms– the standard approach (i.e., following in to the technique of Emmanuel Saez and Stefanie Stantcheva, 2013). In practice, those generalized forms of conventional theory are likely to be di¢ cult to convincingly calibrate, tempting theorists to default to simple principles such as the pure-sum utilitarianism that dominates modern quantitative applications of the theory. This paper’ approach chooses among Pareto-e¢ cient allocations by, s instead, assigning weights to a small number of normative principles with demonstrated empirical relevance.