Adam Smith on Taxation

public finance taxation public policy fiscal policy

Thelmo Vargas-Madrigal for AdamSmithWorks
Costa Rican economist Thelmo Vargas-Madrigal  offers three Adam Smith-inspired public finance lessons for modern day policy-makers.
Editor's Note: This post can be found in Spanish translation here.

Adam Smith Sr., the father of the author of The Theory of Moral Sentiments and The Wealth of Nations, once held in Kirkcaldy, Scotland, the post of Comptroller of Customs, at a time when the aim of economic policy was to export as much as a country could, and to import the minimum, so that a “positive” maximum trade balance was achieved. To this end, high, protectionist duties were levied.

However, Adam Smith Jr., correctly considered that open and free trade was the way to maximize the social benefits of the international division of labor, so that all parties involved would benefit. But Smith expressed opinions –also highly valuable today-- on other kind of taxes.

At present, rich, middle- and low-income countries are facing serious challenges due to the high level of public sector’s debt vis-à-vis the size of their respective economies. The governments of most rich countries can still place bonds in the market at relatively low interest rates, but that is not the case for most developing countries, for which indebtedness above 40% constitute a serious problem.  In its Annual Report 2023, the International Monetary Fund states that “[d]ebt vulnerabilities and risks remain elevated, with emerging market economies and low-income countries especially affected. Among the former, 25 percent are at high risk and facing ‘default-like’ spreads on their sovereign debt.”

The interest component of many low-income public sector budgets crowds out the financing of more and more areas of economic activity typically entrusted to the government—education, health services, infrastructure.  In order to reduce the level of indebtedness (Public-Sector Debt/GDP), policy-makers have access to the following menu: reduce fiscal deficit; negotiate lower interest rates on their debts; adopt measures that help the economy grow at faster rates… and a combination of these actions. Control of non-priority expenditures certainly reduce deficits and thus constitutes the first measure to be adopted.

And, of course, entrusting to the market activities that can be financed with prices instead of taxes helps a lot, as Smith in The Wealth of Nations remind us: “A highway, a bridge, a navigable canal, for example, may in most cases be both made and maintained by a small toll upon the carriages which make use of them”.

In the short run at least, increase in taxation (via higher rates of existing taxes or creation of new ones) helps as well.

As far as taxes is concerned, the so-called Laffer Curve displays the revenue a government obtains from a given tax (e.g., income or sales taxes) grows at a decreasing rate with the increases in the tax rate, forming an inverted “U”, which at some point reaches a maximum, and from there on falls to zero at a tax rate well below 100%. The reason for this is that higher and higher taxes constitute heavier burdens on the productive sector, which promote informality and evasion.

Take the case of the Central American countries now. The current purchasing-power-adjusted per capita income is relatively low in the whole region. In the case of Costa Rica, it is equivalent to a third that of the United States, but for Honduras it is equivalent to only 9%. The poverty levels in the area are high as well: around 20% in the case of Costa Rica, but close to 50% for Guatemala and Honduras. In part, those sad statistics are due to the high levels of unemployment and, specially, informality that operates in those economies. According to the International Labor Organization, informality is around 80% of the labor force in the cases of Honduras and Guatemala.

Informality has adverse effects on the Central Government revenues and in the social security schemes as well. With aging populations, the dependency rate of pay-as-you-go public pension schemes grows, which affects their actuarial soundness and long-term sustainability. In order to avoid bankruptcy, per capita contributions to social security must be elevated and/or the retiring age be raised to, say, 70 or 75 years of age- -measures which attract the opposition of interest groups.

A serious problem faced by social security schemes in most developing countries is that their revenues come from taxing labor. Typically, both employers and employees in the formal sector contribute to the pension schemes in accordance to the wages paid. One important implication of this is that if, for example, for every 100 Pesos of salary the employer is required to pay 18 Pesos extra to the Social Security, and the worker 12, a “wedge” of 30 Pesos is created. A wedge this big constitutes a significant temptation for informality and evasion.

The above circumstance was recognized by Adam Smith about 250 years ago, when writing his masterpiece The Wealth of Nations (which took him 12 years to write). In it he says:
If direct taxes upon wages of labour have not always occasioned a proportionable rise in those wages, it is because they have generally occasioned a considerable fall in the demand for labour. The declension of industry, the decrease of employment for the poor, the diminution of the annual produce of the land and labour of the country, have been the effects of such taxes.
And he adds: 
“High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford smaller revenue to government than what might be drawn from more moderate taxes”.

 Since, according to Dr. Smith, “[e]very tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the state”, three lessons for policy-makers can be extracted:
(a)    Given that indebtedness is the ratio Debt/GDP, the best way to reduce it is to operate on the denominator, by the adoption of pro-growth measures.
(b) In the long run, fiscal deficits cannot be reduced increasing taxes arbitrarily, for that affects the productive capacity of an economy, its tax base and  government revenues. Laffer curve is just a convenient graphical representation of this idea. 
(c) The actuarial soundness of social security schemes can hardly be achieved by increasing payroll taxes. Contributions from the Government budget have to be sought.
Like we say in Spanish: Más claro no canta un gallo!