prior probability

In my previous two posts (see here and here), we have seen why government overborrowing poses such a grave danger to the wealth of a nation. Today, we will take a look at Smith’s surprising and radical solution to this problem, for he proposes nothing less than “a new Utopia” (V.iii.68), a political union between Great Britain and her colonies:

“By extending the British system of taxation to all the different provinces of the empire inhabited by people of either British or European extraction, a much greater augmentation of revenue might be expected. This, however, could scarce, perhaps, be done, consistently with the principles of the British constitution, without admitting into the British Parliament, or if you will into the states general of the British empire, a fair and equal representation of all those different provinces, that of each province bearing the same proportion to the produce of its taxes as the representation of Great Britain might bear to the produce of the taxes levied upon Great Britain. The private interest of many powerful individuals, the confirmed prejudices of great bodies of people seem, indeed, at present, to oppose to so great a change such obstacles as it may be very difficult, perhaps altogether impossible, to surmount. Without, however, pretending to determine whether such a union be practicable or impracticable, it may not, perhaps, be improper, in a speculative work of this kind, to consider how far the British system of taxation might be applicable to all the different provinces of the empire, what revenue might be expected from it if so applied, and in what manner a general union of this kind might be likely to affect the happiness and prosperity of the different provinces comprehended within it. Such a speculation can at worst be regarded but as a new Utopia, less amusing certainly, but not more useless and chimerical than the old one.” (WN, V.iii.68; my emphasis)

But is Smith serious? Does he really believe that a grand political union between Britain and her far-flung colonies would be desirable, let alone feasible? Although the Scottish scholar describes this proposed political union as “a new Utopia” (which leads me to believe that Smith’s bold proposal might just be a ruse or a mere strawman), he nevertheless devotes all of the last 23 pages of the Glasgow edition of The Wealth of Nations, corresponding to paragraphs 69 to 92 of this chapter, to working out the logistical details of taxing the constituent members of this proposed union and to estimating the amount of new tax revenue that such a grand union would generate.

For my part, I am going to skip Adam Smith’s detailed analysis of the logistical details (see, for example, paragraphs 69 to 87 of Book V, Ch. 3), and for the sake of brevity, I will fast-forward to the very last paragraph of The Wealth of Nations (Paragraph #92), where the Scottish scholar reveals his true colours, so to speak. In this concluding passage, Smith contemplates the following “what if?” scenario: what if the people and politicians of Great Britain were to reject his bold proposal? In that case, Smith’s prescription is crystal clear: the central government in London would have to reduce the amount of public spending. Or in the immortal words of Adam Smith:

“If it should be found impracticable for Great Britain to draw any considerable augmentation of revenue from any of the resources above mentioned [i.e. from the expansion of tax collection in the provinces of the new union], the only resource which can remain to her is a diminution of her expence.” (WN, V.iii.92; my emphasis)

It is here, in the very last paragraph of The Wealth of Nations, that Smith concludes his 900-plus-page magnum opus with a scathing critique of “the rulers of Great Britain” for deluding themselves that their debt-ridden government commands a great empire. In reality, says Smith, these rulers are lords of a budgetary black hole (i.e. the colonies), a bottomless money pit and financial house of cards:

“The rulers of Great Britain have, for more than a century past, amused the people with the imagination that they possessed a great empire on the west side of the Atlantic. This empire, however, has hitherto existed in imagination only. It has hitherto been, not an empire, but the project of an empire; not a gold mine, but the project of a gold mine; a project which has cost, which continues to cost, and which, if pursued in the same way as it has been hitherto, is likely to cost, immense expence, without being likely to bring any profit; for the effects of the monopoly of the colony trade, it has been shown, are, to the great body of the people, mere loss instead of profit. It is surely now time that our rulers should either realize this golden dream, in which they have been indulging themselves, perhaps, as well as the people, or that they should awake from it themselves, and endeavour to awaken the people. If the project cannot be completed, it ought to be given up. If any of the provinces of the British empire cannot be made to contribute towards the support of the whole empire, it is surely time that Great Britain should free herself from the expence of defending those provinces in time of war, and of supporting any part of their civil or military establishments in time of peace, and endeavour to accommodate her future views and designs to the real mediocrity of her circumstances.” (WN, V.iii.92; my emphasis)

In other words, Smith is a fiscal conservative, for what he is saying here is that Great Britain’s public debts are unsustainable: she simply cannot afford to subsidize such a large empire and should therefore cut her losses by relinquishing her colonies — or as my colleague and friend Dan Klein would say: Britain should “let ’em go!” [1] For my part, the only thing that I would add is this: Smith’s smack-down of “the rulers of Great Britain” applies with equal force to our (USA’s) elected officials today, of both political parties. According to the Department of Treasury (see here), as of March 2026 the total national debt of the United States exceeds $38 trillion! (By comparison, our nation’s current GDP is just around $29 trillion.) Nota bene: I will offer some concluding thoughts on The Wealth of Nations as a whole starting on Monday, 13 April.

In the middle part of Book V, Chapter 3 of The Wealth of Nations, Adam Smith restates and rebuts two contemporary arguments in defense of government borrowing. The first argument is a proto-Keynesian one:

“The public funds of the different indebted nations of Europe, particularly those of England, have by one author been represented as the accumulation of a great capital superadded to the other capital of the country, by means of which its trade is extended, its manufactures multiplied, and its lands cultivated and improved much beyond what they could have been by means of that other capital only.” (WN, V.iii.47; my emphasis)

The gist of this proto-Keynesian argument is that public debts translate into public spending, and public spending, in turn, contributes to a nation’s GDP. Smith, however, explains why this argument is a based on a logical fallacy:

“He [i.e. the ‘one author’ mentioned in the passage above] does not consider that the capital which the first creditors of the public advanced to government was, from the moment in which they advanced it, a certain portion of the annual produce turned away from serving in the function of a capital to serve in that of a revenue; from maintaining productive labourers to maintain unproductive ones, and to be spent and wasted, generally in the course of the year, without even the hope of any future reproduction…. Had they [the creditors] not advanced this capital to government, there would have been in the country two capitals, two portions of the annual produce, instead of one, employed in maintaining productive labour.” (WN, V.iii.47; my emphasis)

In short, public debts “crowd out” private investment in more productive pursuits. Now, what about the other argument in defense of government borrowing? Smith restates this second argument as follows: “In the payment of the interest of the public debt, it has been said, it is the right hand which pays the left. The money does not go out of the country. It is only a part of the revenue of one set of the inhabitants which is transferred to another, and the nation is not a farthing the poorer.” (WN, V.iii.52) Smith, however, immediately exposes this argument as a cheap accounting trick:

“This apology is founded altogether in the sophistry of the mercantile system, and after the long examination which I have already bestowed upon that system, it may perhaps be unnecessary to say anything further about it. It supposes, besides, that the whole public debt is owing to the inhabitants of the country, which happens not to be true; the Dutch, as well as several other foreign nations, having a very considerable share in our public funds.” (WN, V.iii.52; my emphasis)

Smith then adds for good measure: “But though the whole debt were owing to the inhabitants of the country, it would not upon that account be less pernicious.” (WN, V.iii.52) That is, even if all of a nation’s public debts were from domestic lenders, government overborrowing and the accumulation of public debts would still be bad — not in a moral but in an economic sense. Why? Because, in the immortal words of Adam Smith:

“Land and capital stock are the two original sources of all revenue both private and public. Capital stock pays the wages of productive labour, whether employed in agriculture, manufactures, or commerce. The management of those two original sources of revenue belong to two different sets of people; the proprietors of land, and the owners or employers of capital stock.” (WN, V.iii.53; my emphasis)

Simply put, a nation’s wealth [“revenue, both private and public”] is a function of the amount of land and capital that is put to productive use, but when the government borrows money, that money is no longer available for investment in the private sector. But that is not all, for Smith makes the following ominous observation:

“When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has ever been brought about by bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment.” (WN, V.iii.57; my emphasis)

In other words, when the public debt becomes too large, the government will either have to default on its debts (“bankruptcy”) or perform the “juggling trick” of a currency devaluation (“pretended payment”):

“The raising of the denomination of the coin has been the most usual expedient by which a real public bankruptcy has been disguised under the appearance of a pretended payment…. The honour of a state is surely very poorly provided for when, in order to cover the disgrace of a real bankruptcy, it has recourse to a juggling trick of this kind, so easily seen through, and at the same time so extremely pernicious.” (WN, V.iii.58)

Alas, both options (default and devaluation) are bad because, in both cases, a nation’s wealth is transferred from private creditors, who would have invested that wealth in productive (i.e. revenue-generating) pursuits, to the government, which will then have no incentive to cut back its spending on wars and other wasteful projects. So, what is to be done? How can we avoid either of these dreadful outcomes, i.e. default or devaluation? We will explore Adam Smith’s bold but surprising solution to the problem of government overborrowing in my next post.

“The ordinary expence of the greater part of modern governments in time of peace being equal or nearly equal to their ordinary revenue, when war comes [governments] are both unwilling and unable to increase their revenue in proportion to the increase of their expence.” (WN, V.iii.37; my emphasis)

I concluded my previous post with the following words: “… Smith identifies yet another method of government borrowing — one that occupies a ‘middle place” between temporary ‘anticipations’ and ‘perpetual funding’.” (WN, V.iii.29) What is this intermediate method? According to Adam Smith, “These are, that of borrowing upon annuities for terms of years, and that of borrowing upon annuities for lives.” (V.iii.29) In a word: bonds or what Smith calls “annuities”.

As an aside, Smith concludes that “[i]n France a much greater proportion of the public debts consists in annuities for lives than in England.” (V.iii.34) Why are lifetime annuities more popular than long-term annuities in France than in England? For Smith, this difference in public finance “arises altogether from the different views and interests of the lenders” in both countries. More specifically, according to Smith, investors in England are shrewd merchants who value liquidity, and long-term annuities are easier to resell than lifetime annuities:

“In England, the seat of government being in the greatest mercantile city in the world, the merchants are generally the people who advance money to government. By advancing it they do not mean to diminish, but, on the contrary, to increase their mercantile capitals, and unless they expected to sell with some profit their share in the subscription for a new loan, they never would subscribe. But if by advancing their money they were to purchase, instead of perpetual annuities, annuities for lives only, whether their own or those of other people, they would not always be so likely to sell them with a profit. Annuities upon their own lives they would always sell with loss, because no man will give for an annuity upon the life of another, whose age and state of health are nearly the same with his own, the same price which he would give for one upon his own. An annuity upon the life of a third person, indeed, is, no doubt, of equal value to the buyer and the seller; but its real value begins to diminish from the moment it is granted, and continues to do so more and more as long as it subsists. It can never, therefore, make so convenient a transferable stock as a perpetual annuity, of which the real value may be supposed always the same, or very nearly the same.” (V.iii.35)

In France, however, the market for public debt is different, for many investors consist of wealthy bachelors who have less need for liquidity and who instead prefer the soundness and dependability of receiving a dependable stream of payments during their lifetimes:

“In France, the seat of government not being in a great mercantile city, merchants do not make so great a proportion of the people who advance money to government. The people concerned in the finances, the farmers general, the receivers of the taxes which are not in farm, the court bankers, &c. make the greater part of those who advance their money in all public exigencies. Such people are commonly men of mean birth, but of great wealth, and frequently of great pride. They are too proud to marry their equals, and women of quality disdain to marry them. They frequently resolve, therefore, to live bachelors, and having neither any families of their own, nor much regard for those of their relations, whom they are not always very fond of acknowledging, they desire only to live in splendour during their own time, and are not unwilling that their fortune should end with themselves. The number of rich people, besides, who are either averse to marry, or whose condition of life renders it either improper or inconvenient for them to do so, is much greater in France than in England. To such people, who have little or no care for posterity, nothing can be more convenient than to exchange their capital for a revenue which is to last just as long, and no longer, than they wish it to do.” (V.iii.36)

Although one might be tempted to dismiss Smith’s analysis here as anachronistic or out-of-date, the Scottish scholar quickly redeems himself. After comparing and contrasting the markets for public debt in England and France, Smith poses a deeper and more timeless question: why do government overborrow in the first place? Why does public spending always end up exceeding the amount of public revenue collected via taxes? In a word, Smith’s answer is war: “when war comes,” politicians are “unwilling” to increase taxes “for fear of offending the people”:

“The ordinary expence of the greater part of modern governments in time of peace being equal or nearly equal to their ordinary revenue, when war comes they are both unwilling and unable to increase their revenue in proportion to the increase of their expence. They are unwilling for fear of offending the people, who, by so great and so sudden an increase of taxes, would soon be disgusted with the war; and they are unable from not well knowing what taxes would be sufficient to produce the revenue wanted. The facility of borrowing delivers them from the embarrassment which this fear and inability would otherwise occasion. By means of borrowing they are enabled, with a very moderate increase of taxes, to raise, from year to year, money sufficient for carrying on the war, and by the practice of perpetually funding they are enabled, with the smallest possible increase of taxes, to raise annually the largest possible sum of money. In great empires the people who live in the capital, and in the provinces remote from the scene of action, feel, many of them, scarce any inconveniency from the war; but enjoy, at their ease, the amusement of reading in the newspapers the exploits of their own fleets and armies. To them this amusement compensates the small difference between the taxes which they pay on account of the war, and those which they had been accustomed to pay in time of peace. They are commonly dissatisfied with the return of peace, which puts an end to their amusement, and to a thousand visionary hopes of conquest and national glory from a longer continuance of the war.” (V.iii.37; my emphasis)

But what happens after these wars end? How will the government be able to repay all the money it has borrowed to subsidize its wars and other overseas entanglements? I will address this key question in my next post.

Adam Smith surveys several methods in Book V, Chapter 3 of The Wealth of Nations by which a government can borrow money. He begin his comprehensive survey with two types of public debt: “unfunded debts” (V.iii.11) and “mortaged debts” (V.iii.12), followed by a stinging critique of government overborrowing:

1. UNFUNDED PUBLIC DEBTS

To begin, Smith identifies two types of unfunded public debts: “What is called the unfunded debt of Great Britain, is contracted in … two ways. It consists partly in a debt which bears, or is supposed to bear, no interest, and which resembles the debts that a private man contracts upon account, and partly in a debt which bears interest, and which resembles what a private man contracts upon his bill or promissory note.” (V.iii.11)

The first type of unfunded debt thus consists of one-off, non-interest bearing IOUs — when the government needs money pronto to pay its own armed forces or to bribe foreign leaders: “The debts which are due either for extraordinary services, or for services either not provided for, or not paid at the time when they are performed, part of the extrordinaries of the army, navy, and ordnance, the arrears of subsidies to foreign princes, those of seamen’s wages, &c. usually constitute a debt of the first kind ….” (V.iii.11)

The second type of unfunded debt consists of interest-bearing “Navy and exchequer bills.” (ibid.) The government must pay back what it borrows plus interest: “… Navy and exchequer bills, which are issued sometimes in payment of a part of such [extraordinary military] debts and sometimes for other purposes, constitute a debt of the second kind—exchequer bills bearing interest from the day on which they are issued, and navy bills six months after they are issued.” (ibid.) This second type of unfunded debt consists of interest-bearing promissory notes or IOUs issued by the Bank of England: “The Bank of England, either by voluntarily discounting those bills at their current value, or by agreeing with government for certain considerations to circulate exchequer bills, that is, to receive them at par, paying the interest which happens to be due upon them, keeps up their value and facilitates their circulation, and thereby frequently enables government to contract a very large debt of this kind.” (ibid.)

2. MORTGAGED PUBLIC DEBTS

Next, Smith identifies two types of “mortgaged debts” (so to speak) — public debt raised by anticipation and public debt raised by perpetual funding — in which the government earmarks the revenue from specific taxes (taxes on beer, salt, etc.), either for a number of years or in perpetuity(!), to pay back those public debts:

“When this resource is exhausted, and it becomes necessary, in order to raise money, to assign or mortgage some particular branch of the public revenue for the payment of the debt, government has upon different occasions done this in two different ways. Sometimes it has made this assignment or mortgage for a short period of time only, a year, or a few years, for example; and sometimes for perpetuity. In the one case the fund was supposed sufficient to pay, within the limited time, both principal and interest of the money borrowed. In the other it was supposed sufficient to pay the interest only, or a perpetual annuity equivalent to the interest, government being at liberty to redeem at any time this annuity upon paying back the principal sum borrowed. When money was raised in the one way, it was said to be raised by anticipation; when in the other, by perpetual funding, or, more shortly, by funding.” (V.iii.12)

3. SMITH’S STINGING CRITIQUE OF GOVERNMENT OVERBORROWING

After reviewing the history of the British government’s fiscal policies going back to 1697, Smith identifies a troubling pattern: “In consequence of those different acts [by the British government going back to 1697], the greater part of the taxes which before had been anticipated only for a short term of years were rendered perpetual as a fund for paying, not the capital, but the interest only, of the money which had been borrowed upon them by different successive anticipations.” (V.iii.25; my emphasis)

But it’s not just the British government that has been fiscally irresponsible. Smith rebukes “the greater part of European governments” for “overloading” their public debts (i.e. overborrowing) in the following passage:

“Had money never been raised but by anticipation, the course of a few years would have liberated the public revenue without any other attention of government besides that of not overloading the fund by charging it with more debt than it could pay within the limited term, and of not anticipating a second time before the expiration of the first anticipation. But the greater part of European governments have been incapable of those attentions. They have frequently overloaded the fund even upon the first anticipation, and when this happened not to be the case, they have generally taken care to overload it by anticipating a second and a third time before the expiration of the first anticipation. The fund becoming in this manner altogether insufficient for paying both principal and interest of the money borrowed upon it, it became necessary to charge it with the interest only, or a perpetual annuity equal to the interest, and such unprovident anticipations necessarily gave birth to the more ruinous practice of perpetual funding. But though this practice necessarily puts off the liberation of the public revenue from a fixed period to one so indefinite that it is not very likely ever to arrive, yet as a greater sum can in all cases be raised by this new practice than by the old one of anticipations, the former, when men have once become familiar with it, has in the great exigencies of the state been universally preferred to the latter. To relieve the present exigency is always the object which principally interests those immediately concerned in the administration of public affairs. The future liberation of the public revenue they leave to the care of posterity.” (V.iii.26; my emphasis)

In other words, governments like to overborrow not because politicians like to spend other people’s money, but because they like to spend future people’s money! Politicians are focused on problems that require immediate (and expensive!) solutions. They thus borrow (steal?) all the money they can now, leaving it to future taxpayers to pay the bill later! Adam Smith thus deserves the title of father of public choice theory, alongside James Buchanan and Gordon Tullock.

Nota bene: In addition to these two types of public debts, Smith identifies yet another method of government borrowing — one that occupies a “middle place” between temporary “anticipations” and “perpetual funding”. (V.iii.29) We will proceed to this intermediate method in my next post.

I began this series of daily Adam Smith blog posts (excluding Sundays) way back on January 2nd (see here), starting with Book I, Chapter 1 on The Wealth of Nations — the deservedly-famous “division of labour” chapter. Now, almost four months later, we have finally arrived at the last chapter of Adam Smith’s magnum opus: Book V, Chapter 3, available here (WN, V.iii.1-92). This concluding chapter may take us the entire week to review, if not more, for it contains 92 dense paragraphs spread across 71 pages of the Glasgow edition of Smith’s classic work.

To begin, let’s put this final chapter into context. In the previous two chapters, Smith surveys the main duties of government (Chapter 1) as well as the main methods of taxation for the financing of these public duties (Chapter 2). Here (Chapter 3), Smith tackles the problem of “publick debts” — i.e. when government spending exceeds tax revenue and the government must thus borrow money from third parties in order to finance its public works — and he makes several timeless observations in the first 10 paragraphs of this chapter alone! Among other things, the Scottish scholar presents the following six points:

1. ALL GOVERNMENTS LOVE TO SPEND OTHER PEOPLE’S MONEY

“The parsimony which leads to accumulation has become almost as rare in republican as in monarchical governments. The Italian republics, the United Provinces of the Netherlands, are all in debt. The canton of Berne is the single republic in Europe which has amassed any considerable treasure. The other Swiss republics have not. The taste for some sort of pageantry, for splendid buildings, at least, and other public ornaments, frequently prevails as much in the apparently sober senate-house of a little republic as in the dissipated court of the greatest king.” (V.iii.3; my emphasis)

2. WARS ARE NOT ONLY COSTLY; THEY ARE ALSO THE MAIN SOURCE OF PUBLIC DEBT

“The want of parsimony in time of peace imposes the necessity of contracting debt in time of war. When war comes, there is no money in the treasury but what is necessary for carrying on the ordinary expence of the peace establishment…. But the moment in which war begins, or rather the moment in which it appears likely to begin, the army must be augmented, the fleet must be fitted out, the garrisoned towns must be put into a posture of defence; that army, that fleet, those garrisoned towns must be furnished with arms, ammunition, and provisions. An immediate and great expence must be incurred in that moment of immediate danger, which will not wait for the gradual and slow returns of the new taxes. In this exigency government can have no other resource but in borrowing.” (V.iii.4; my emphasis)

3. WHEN GOVERNMENT SPENDING EXCEEDS TAX REVENUE, THE GOVERNMENT MUST BORROW MONEY FROM THIRD PARTIES

“The same commercial state of society which, by the operation of moral causes, brings government in this manner into the necessity of borrowing, produces in the subjects both an ability and an inclination to lend.” (V.iii.5)

4. THE MORE WEALTHY A COUNTRY IS, THE EASIER IT IS FOR THE GOVERNMENT TO BORROW MONEY

“A country abounding with merchants and manufacturers, therefore, necessarily abounds with a set of people who have it at all times in their power to advance, if they choose to do so, a very large sum of money to government. Hence the ability in the subjects of a commercial state to lend.” (V.iii.6; my emphasis)

5. BUT HOW DOES A COUNTRY BECOME WEALTHY? BY ESTABLISHING THE RULE OF LAW

“Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law, and in which the authority of the state is not supposed to be regularly employed in enforcing the payment of debts from all those who are able to pay. Commerce and manufactures, in short, can seldom flourish in any state in which there is not a certain degree of confidence in the justice of government. The same confidence which disposes great merchants and manufacturers, upon ordinary occasions, to trust their property to the protection of a particular government, disposes them, upon extraordinary occasions, to trust that government with the use of their property.” (V.iii.7; my emphasis)

6. EXCESSIVE PUBLIC DEBT IS THE DOWNFALL OF NATIONS

“The progress of the enormous debts which at present oppress, and will in the long-run probably ruin, all the great nations of Europe has been pretty uniform. Nations, like private men, have generally begun to borrow upon what may be called personal credit, without assigning or mortgaging any particular fund for the payment of the debt; and when this resource has failed them, they have gone on to borrow upon assignments or mortgages of particular funds.” (V.iii.10; my emphasis)

Simply put, the problem of “publick debts” can be compared to a slow but fatal illness — one of two mortal diseases, I might add, that have been the downfall of all systems of government. (Can you identify what the other public malady is? If not, see note #1 below the fold.) But can the disease of public debt be cured if identified and treated early on? Does this affliction have a cure? Read on!

PREVIEW OF TOMORROW’S POST: FOUR METHODS OF BORROWING

Next (see especially Paragraphs 11 to 26 of Chapter 3 of Book V), Smith surveys four methods by which a government can borrow money, i.e. dig its own financial grave. We will describe these four methods of government borrowing and discuss their pros and cons in my next post.

Happy Easter Monday! Before we jump into the last chapter of The Wealth of Nations, I have to confess that Adam Smith’s 900-plus-page masterpiece has taken up a lot of my time these past few months. But that is not the only tome that I have been studying during this time! Among other things, I have also been reading the following mix of classic and contemporary works, including The Meditations of Marcus Aurelius (Martin Hammond translation; Penguin classics edition) and The Enchiridion of Epictetus (Elizabeth Carter translation, available here), as well as the following:

1. Tyler Cowen, The Marginal Revolution: Rise and Decline, and the Pending AI Revolution (Mercatus Center, 2026, available here). Cowen surveys the history of the marginal revolution in economics and explains why thinking “at the margin” is the best thing since sliced bread.
2. Zia Haider Rahman, In the Light of What We Know (Farrar, Straus and Giroux, 2014). I discovered this acclaimed work of fiction by chance on my Twitter feed. Spoiler alert or trigger warning (take your pick): the two main protagonists of this novel are erudite but despicable fellows: one is a two-timer who betrays his best friend; the other is a rapist.
3. Jacob “I Just Make Shit Up” Soll, Free Market: The History of an Idea (Basic Books, 2022). I want my money back: the chapter on Adam Smith, for example, contains so many errors of fact and reckless revisionist history that I am pretty sure it was generated — either in part or in its entirety — by an early version of ChatGPT!

My translation of the title of this beautiful Spanish hymn: Everlasting Saviour

“The French system of taxation seems, in every respect, inferior to the British.” (WN, V.ii.k.78)

For part 1, see here. Adam Smith concludes his lengthy survey of “Taxes upon consumable Commodities” in Chapter 2 of Book V of The Wealth of Nations (see especially WN, V.ii.k.70-78) with some final observations about “the French system of taxation”:

“In France, the greater part of the actual revenue of the crown is derived from eight different sources; the taille, the capitation, the two vingtiemes, the gabelles, the aides, the traites, the domaine, and the farm of tobacco.” (WN, V.ii.k.76)

Smith further describes how these eight different sources of tax revenue are levied by two entirely different and non-overlapping set of tax officials:

The five last [i.e. the gabelles, the aides, the traites, the domaine, and the farm of tobacco] are, in the greater part of the provinces, under farm. The three first [i.e. the taille, the capitation, the two vingtiemes] are every where levied by an administration under the immediate inspection and direction of government, and it is universally acknowledged that, in proportion to what they take out of the pockets of the people, they bring more into the treasury of the prince than the other five, of which the administration is much more wasteful and expensive.” (WN, V.ii.k.76)

Before proceeding, some historical background is in order. Specifically, Smith’s phrase “under farm” refers to France’s tax farm system, the Ferme générale, which was a privatized tax collection system in which private investors (tax farmers) paid the crown an up-front sum for the right to collect certain taxes (cf. the five taxes listed by Smith above), profiting from any surplus collected. So, what about taxes of consumption goods — the ostensible subject of this subsection of Smith’s magnum opus? How should these taxes be collected, under farm or by the government?

Today is Good Friday or “Viernes Santo” in Spanish, the most solemn day in the Catholic liturgical year.

As we saw in my previous post (see here), Adam Smith’s comprehensive survey of “Taxes upon Consumable Commodities” in Book V, Chapter 2, Part 2, Article 4 of The Wealth of Nations (WN, V.ii.k) contains a short but insightful analysis of the economics of smuggling, but in addition, in the course of his discussion on smuggling, the Scottish scholar makes another timeless observation about the relative merits of excise taxes versus customs duties. Let me explain:

First off, recall from my previous post Smith’s timeless observation about the direct relationship between the level of taxes on consumption goods and the level of smuggling of those same goods. In short, it is “high taxes” that “encourag[es] smuggling” (V.ii.k.33); the higher those consumption taxes are, the more smuggling will occur. Next, the Scottish scholar identifies two ways of reducing smuggling:

“… it [the smuggling of consumption goods] may perhaps be remedied in two ways; either by diminishing the temptation to smuggle, or by increasing the difficulty of smuggling. The temptation to smuggle can be diminished only by the lowering of the tax, and the difficulty of smuggling can be increased only by establishing that system of administration which is most proper for preventing it.” (V.ii.k.35; my emphasis)

In other words, incentives matter! The government can reduce the level of smuggling by changing the incentive structure of smugglers in one of two ways: either by lowering the taxes on the goods being smuggled in (thus reducing the pecuniary temptation to smuggle in those goods in the first place) or by making it more difficult to evade detection. On this note, Smith explains why “[t]he excise laws … obstruct and embarrass the operations of the smuggler much more effectually than those of the customs.” (V.ii.k.36) Why? For Smith, there are three reasons why excise taxes > customs duties: “simplicity, certainty, and precision.” (cf. V.ii.k.38)

According to Smith, excise taxes are more simple, certain, and precise than customs duties because excise taxes are imposed on all designated goods produced or sold domestically, while customs duties are levied only on goods crossing international borders (imports or exports, or both). In other words, trying to figure out which goods are meant for export and which goods are imports is more costly and cumbersome than trying to figure out which goods were produced or sold in the home market. (In addition, custom duties are easier to evade than excise taxes are because custom duties are collected only at designated border checkpoints, which smugglers can find ways of bypassing, while excise taxes are collected at the point of production, distribution, or sale, depending on how the excise tax is designed.)

More importantly, Adam Smith then concludes his discussion of smuggling with the following general observations:

“… if every duty was occasionally either heightened or lowered according as it was most likely, either the one way or the other, to afford the greatest revenue to the state, taxation being always employed as an instrument of revenue and never of monopoly, it seems not improbable that a revenue at least equal to the present net revenue of the customs might be drawn from duties upon the importation of only a few sorts of goods of the most general use and consumption, and that the duties of customs might thus be brought to the same degree of simplicity, certainty, and precision as those of excise.” (V.ii.k.38; my emphasis)

In plain English, in the above passage Smith is making the following points:

1. The purpose of taxation is to raise revenue, not to favor one lobby group over another (e.g. farmers, homeowners, etc.), a lesson that, alas, has clearly been lost on us today.
2. Sometimes the government can collect more tax revenue by lowering tax rates. (See also Part C of my previous post.)
3. Excise taxes (e.g. sales taxes) are more simple, certain, and precise than customs duties.

To recap, simpler tax systems are better because they are more certain and more precise than complex tax systems are. Nota bene: I will conclude my survey of Article 4 of Part 2, Ch. 2, Book V of Smith’s magnum opus in my next post.

We now turn to the last major subsection of Book V, Chapter 2 of The Wealth of Nations: “Taxes upon Consumable Commodities” (WN, V.ii.k). Here, Adam Smith makes a number of timeless points, all of which are still relevant today:

A. NEEDS VERSUS WANTS: SMITH’S BROAD DEFINITION OF ‘NECESSARIES’

First off, Smith not only identifies two major types of consumer goods — “necessaries” and “luxuries” — he also explains in Paragraph 3 of this subsection why needs should be defined broadly:

“By necessaries I understand not only the commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without. A linen shirt, for example, is, strictly speaking, not a necessary of life. The Greeks and Romans lived, I suppose, very comfortably though they had no linen. But in the present times, through the greater part of Europe, a creditable day-labourer would be ashamed to appear in public without a linen shirt, the want of which would be supposed to denote that disgraceful degree of poverty which, it is presumed, nobody can well fall into without extreme bad conduct. Custom, in the same manner, has rendered leather shoes a necessary of life in England. The poorest creditable person of either sex would be ashamed to appear in public without them…. Under necessaries, therefore, I comprehend not only those things which nature, but those things which the established rules of decency have rendered necessary to the lowest rank of people. All other things I call luxuries ….” (WN, V.ii.k.3; my emphasis)

B. THE ECONOMICS OF TAXES ON CONSUMER GOODS DEPENDS ON WHAT TYPE OF GOODS ARE BEING TAXED: NECESSARIES OR LUXURIES

Why does Smith draw this distinction between necessary goods and luxury goods? Because for Smith the economics of a sales tax depends on the type of good being taxed. According to the Scottish scholar, the ultimate effect of a tax on necessary goods is to “diminish the extent of their sale and consumption.” (WN, V.ii.k.9) Why? Because a tax on necessary goods produces the following three-step chain reaction:

1. Initiation phase (step one): A tax on necessary goods will increase the prices of those good by at least the amount of the tax, if not more (see WN, V.ii.k.4)
2. Propagation phase (step two): This overall increase in the prices of necessary goods will then have the macro effect of increasing the cost of labour because workers will need to be paid more in order to afford those necessary goods (ibid.)
3. Termination phase (step three): An increase in the cost of labour will, in turn, further increase the cost of consumer goods (WN, V.ii.k.5)

A sales tax on luxury goods, by contrast, will not increase the cost of labour: “It is otherwise with taxes upon what I call luxuries, even upon those of the poor. The rise in the price of the taxed commodities will not necessarily occasion any rise in the wages of labour.” (WN, V.ii.k.6) To recap:

“Taxes upon luxuries have no tendency to raise the price of any other commodities except that of the commodities taxed. Taxes upon necessaries, by raising the wages of labour, necessarily tend to raise the price of all manufactures, and consequently to diminish the extent of their sale and consumption.” (WN, V.ii.k.9)

C. HIGH TAXES WILL GENERATE LESS TAX REVENUE

Last (for now), but not least, Smith explains why high taxes on consumer goods — regardless whether such goods are classified as necessaries or luxuries — can be counter-productive in one of two ways:

“High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes.” (WN, V.ii.k.33)

In order words, demand curves slope downward: there is an inverse relationship between a good’s price and the quantity demanded, so the higher the tax on good X, the lower the demand for X. In addition, high taxes on consumer goods create perverse incentive effects: they stimulate smugglers to find new and creative ways to evade the tax in the first place — and the higher the tax, the more lucrative this black-market incentive is!

D. ADAM SMITH’S BOTTOM LINE: TAX LUXURIES, NOT NECESSARIES

After his discussion of smuggling — of which I will have more to say in my next post — Smith concludes: “It must always be remembered, however, that it is the luxurious and not the necessary expence of the inferior ranks of people that ought ever to be taxed.” (WN, V.ii.k.44; my emphasis) Nota bene: I will discuss Adam Smith’s expert analysis of the economics of smuggling in greater detail in my next post.