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Book 5, Chapter 1
Themes
and Colors
Key
LitCharts assigns a color and icon to each theme in The Wealth of Nations, which you can use to track the themes throughout the work.
Labor, Markets, and Growth
Capital Accumulation and Investment
Institutions and Good Governance
Mercantilism and Free Trade
Money and Banking
Summary
Analysis
The sovereign can gain income from any property it owns, and by taxing the people.
Governments can earn the revenue they need to operate in several ways. Taxes are the most common and most desirable option, but not the only one. In the last chapter, Smith noted how governments can earn money from charging fees and tolls, and he will start this one by explaining how they can earn profits from their investments and rent from their land holdings. Lastly, in his final chapter, he will explore how some governments also borrow money—a practice that was relatively new when he was writing in the 18th century, but which is universal today.
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“Part I. Of the Funds or Sources of Revenue which may peculiarly belong to the Sovereign or Commonwealth.” The sovereign can own stock, which it can lend or invest. In tribal herding societies, like the Tartars (Turks) or Arabs, the sovereign’s stock consists of the chief’s herds, and its revenue is the profit those herds generate (as they multiply and yield milk). In mercantile republics like Hamburg, Venice, and Amsterdam, the sovereign’s revenue can come mostly from profits on trade, banking, and post offices. Princes generally make poor merchants because they have poor business sense. Indeed, merchants also make poor sovereigns, as the East India Company’s financial troubles show.
Like any capital owner, the state can derive revenue from investing its stock in any number of ways—which will produce different returns, depending on the structure of the economy. Tribal herders and modern commercial republics are similar because they both essentially run their governments as businesses and use those businesses’ profits to pay for administration, justice, defense, and so on. But Smith again warns the reader about merchants’ natural incentive to establish monopolies—concretely, if self-interested merchants run the government, they can use it to crush free competition, raise prices while lowering quality, and enrich themselves at the people’s expense.
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Sovereigns can also earn interest by lending money and treasure. The Swiss canton of Berne lends money to other states, while Hamburg runs a public pawn shop and Pennsylvania issues paper credit similar to banknotes, using land as collateral. But stock and credit are too “unstable and perishable” to fund a government long-term.
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Land is comparatively secure, and so most advanced countries fund the sovereign primarily through land rents. In ancient Greece, ancient Rome, and feudal Europe, large, landed estates could cover the sovereign’s costs. This is because most people were trained soldiers, so the sovereign’s main expense—war—was cheap. But in modern European countries, land taxes cannot cover the sovereign’s expenses. Britain’s land tax applies to all land, houses, and interest earned on capital stock, but it still doesn’t cover the state’s revenue. As private people manage land better than the state, the more land the crown manages, the less it will earn in land taxes and the less the land will produce. Thus, Europe’s monarchies should sell most of the lands they own, except for parks.
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“Part II. Of Taxes.” In most cases, the sovereign’s general revenue must come primarily from taxes. It can tax rents, profits, wages, or all three. Four key principles apply to all four kinds of taxes. First, taxes should be equal—people should pay proportionately to their revenue. Second, taxes should be clearly defined in advance so they are certain, not arbitrary. Third, taxes should be paid when it’s most convenient, so sales taxes should be charged when people buy goods, rent taxes when they pay rent, and so on. Fourth, people should be taxed no more than is necessary, and the tax system should not burden them with further costs. For instance, taxes may prove expensive to collect, suppress certain kinds of business, encourage smuggling and tax evasion (and bankrupt lawbreakers who get caught), and waste people’s time.
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“Article I. Taxes upon Rent. Taxes upon the Rent of Land.” Land can be taxed at a constant value, or in proportion to its real value. Constant land taxes, like the one in Britain, lead to inequality because some land gets improved, and some does not. Such taxes are easy to collect, and Britain’s has enriched the country’s landlords (but deprived the sovereign of revenue) because rents have risen significantly, while silver prices haven’t. So constant land taxes can have unpredictable effects, depending on other economic factors.
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French economists argue that the fairest tax is one proportional to the land rent. For instance, Venice taxes all land at 10% of its rent (or 8% for farmers who cultivate their own land). This is more equal than a constant land tax, but it requires more complex administration. Landlords and tenants should register their leases with the government, and landlords should be taxed more if they charge lease renewal fees instead of increasing the rent, try to specify how their land should be cultivated, or make tenants pay rent in rude produce. Tax breaks should encourage landlords to cultivate their own land, like in Venice. With these changes, a variable tax system would not be very expensive to administer, and it would encourage people to improve their lands (although they should not have to pay taxes on those improvements for the first few years).
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Proportional land taxes can adapt to changes in land improvement, the economy, and silver prices. Different countries have administered them in diverse ways. Prussia, Silesia, and Bohemia actually conducted land surveys for their rent taxes. Prussia rightly charges the church a higher tax rate, because it doesn’t improve its land, but many states charge it less. Silesia reasonably taxes the nobility higher, but Sardinia and some parts of France don’t tax the nobility at all. Montauban had to impose additional taxes because its land survey valuations quickly became outdated.
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“Taxes which are proportioned, not to the Rent, but to the Produce of Land.” Proportional taxes payable in rude produce, like the church’s tithe, may look like income taxes on farmers, but they’re really land taxes on landlords. Farmers always predict them in advance and factor them into the following year’s harvest. Such taxes are very unequal, as some lands produce a much larger surplus than others and should have much higher rents as a result. Put differently, 10% of a fertile land’s rude produce might only be a fifth of the landlord’s rent, while 10% of a barren land’s produce could be most of their rent. Such taxes discourage landlords from improving their lands and farmers from cultivating them well.
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Historically, China, Bengal, and Egypt imposed such taxes, which gave the state an incentive to build infrastructure. But tithes in Europe don’t have this benefit, as the church’s lands are small and dispersed. Collecting these taxes in rude produce is inconvenient and leads to fraud, so it’s better to collect them in money, depending on the market price of rude produce in any given year. If the price is instead fixed from year to year, these taxes become no different from constant land taxes, like Britain’s.
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“Taxes upon the Rent of Houses.” House rent has two parts. Building rent pays for the cost of the construction, plus the ordinary rate of interest (so that the builder can make a profit). Ground rent pays for the cost of the land. Ground rent is higher wherever there is more demand, like in cities. In the countryside, ground rent is usually whatever the land would yield if it were instead used as farmland. Taxes on house rent don’t affect the cost of building, so they ultimately increase the ground rent, which affects both tenants and landlords. They reduce competition for houses at higher rents but increase it at the lowest rents. Since the rich spend more of their income on rent than the poor (who mostly spend it on food), house rents disproportionately affect the rich. But this is reasonable, as the rich can afford to pay more.
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Unlike land, houses are not productive, so people have to pay taxes on house rent from their other income sources. High house rent taxes would also encourage people to spend their money more productively. Like land rent taxes, house rent taxes can be assessed based on the market rent (including for owner-occupied houses). Ground rent is the best rent to tax, as landlords do not actively use their lands, a uniform tax will not change their propensity to rent it out, and the sovereign can reasonably take credit for certain lands becoming desirable places to live (and yielding high ground rents). European countries haven’t yet singled out the ground rent for taxation, but they should.
England applies its land rent tax to houses, too, but its valuations are very unfair. Holland taxes houses based on their value for sale, not rent. But this is difficult to calculate. England long taxed houses based on the number of hearths or windows instead, but this is unfair to the poor because it doesn’t account for the much higher property values in major cities like London. All taxes on houses lower rents, because the more someone pays in taxes, the less they can afford in rent.
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“Article II. Taxes upon Profit, or upon the Revenue arising from Stock.” Profit has two parts. One part is interest, which pays back the stockowner’s investment at an ordinary profit rate. The other part is the surplus earned in exchange for employing the capital. Taxes on profits force employers to either raise their profit rates or pay less in interest, and they pass these costs on to either farmers (if they’re investing in land) or consumers (if they’re manufacturers).
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Taxing interest may seem advantageous, because interest is like ground rent: it is a market price which taxation will not change. (Rather, taxes effectively deduct a portion of the investor or landlord’s earnings.) But taxing interest is actually a mistake, because calculating interest earnings is very difficult and invasive, and people may take their capital stock out of the country to avoid taxes. Countries that have tried to tax stock revenues have done so at very low, approximate rates—which is similar to how England has implemented its land tax.
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No country has seriously inquired into its citizens’ private wealth in order to assess taxes. Hamburg asks citizens to pay 0.25% of their wealth annually in taxes on an honor system. In some parts of Switzerland, they also publicly declare their net worth. These small annual taxes are all meant to be taxes on interest. Holland once assessed a one-time 2% tax on net worth after establishing a new government—which was meant to be a tax on capital.
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“Taxes upon the Profit of particular Employments.” Some countries impose special taxes on certain occupations, like street hawkers and pubs. Businesses always pass these costs on to consumers. These taxes are fairest when proportional to profits, and they hurt smaller businesses if they are one-time licensing fees. Britain abandoned plans to tax shops because it would have been impossible to measure their business, but unfair to tax them all equally.
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France does tax the profits of agricultural stock. Historically, it taxed common people who owned land but not nobles, who were too powerful and refused to pay. Now, in the 18th century, it recalculates people’s tax liabilities every year, depending on a council’s assessment of regional variations in land, harvest quality, people’s ability to pay, and other relevant conditions. These assessments are never accurate. More often, they’re biased and unpredictable. Farmers won’t reasonably under-cultivate their lands or pass costs onto consumers, so this tax just reduces land rents, passing the cost on to landlords. However, since the tax is based on the capital invested in agriculture, farmers do try to appear as poor as possible by working with cheap hand tools instead of animals or finer tools.
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In North America and the West Indies, the colonial governments assess “poll-taxes” on planters for every person they enslave. These taxes reflect the planters’ status as citizens, while the people they enslave are their property. Thus, these taxes are reasonable. They would be unfair if assessed on free laborers. Britain and Holland’s taxes on menial servants are similar, and they primarily affect middle-ranking people who keep servants. All these taxes on particular businesses do not affect interest rates, since merchants in these businesses still buy credit in the same market with people in other businesses, who are not subject to the taxes. (But taxes on all businesses do affect interest rates.)
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“Appendix to Articles I and II. Taxes upon the Capital Value of Land, Houses, and Stock.” Taxes on the transfer (sale or inheritance) of land and real estate are easy to assess because these transactions are difficult to hide from the public. The transfer of capital and movable property is harder to tax, since it can be secret. The best solution is to require the payment of stamp-duties and registration fees in exchange for deeds of sale to be valid. The Romans imposed an inheritance tax, the Dutch still do, and European monarchies imposed complex property transfer taxes in the feudal era. Britain’s transfer taxes aren’t proportional to property value, while only some of Holland’s are. In France, different agencies collect the stamp-duties and the registration fees.
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Inheritance taxes fall on the heirs, while land and property sale taxes fall on sellers (except taxes on new buildings, which fall on buyers). Borrowers cover the registration and stamp fees for loans, while both parties do for lawsuits. All these transfer taxes harm the national revenue, as they increase the state’s revenue by taking away capital stock that would otherwise be invested in productive labor. Transfer taxes are unequal, since some people transfer property more often than others, but they are very easy to assess. The French complain endlessly about their unfair property registration system, but not their stamp-duties. Property sale registers are very beneficial because they give security to buyers, sellers, and the public alike. But these registers cannot be secret, or else officials will abuse them. Finally, stamp-duties on products like newspaper and liquor are really consumption taxes.
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“Article III. Taxes upon the Wages of Labour.” All production requires labor, so a tax on wages increases the price of everything. This means wages must rise not only by the amount of the tax, but also by a bit more, to cover these higher prices. Employers pass higher labor costs on to consumers in the form of higher prices, while farmers pass them on to landlords in the form of lower rents. In manufacturing, such taxes deter hiring, harm industry, and reduce the nation’s annual produce. Yet countries like France and Bohemia still assess them. Taxing government workers is a more reasonable and popular solution, as they tend to be overpaid.
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“Article IV. Taxes which, it is intended, should fall indifferently upon every different Species of Revenue.” People must pay capitation taxes (yearly taxes assessed on every person) and taxes on consumable commodities with whatever revenue they happen to have, whether it comes from profit, rent, or wages.
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“Capitation Taxes.” Assessing people’s wealth and income is difficult and invasive, so proportional capitation taxes are usually arbitrary and unfair. Capitation taxes based on rank are less uncertain, but still deeply unfair. Either way, these taxes must be very low, or else people will neither afford nor tolerate them. Still, unfair taxes are more tolerable than unpredictable ones. England historically taxed people based on rank, while France taxes the nobility based on rank and commoners based on wealth. But France imposes its tax more strictly than England. Capitation taxes on workers are equivalent to taxes on wages. But they’re easy to administer, so governments have often chosen them, even though they hurt the poor.
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“Taxes upon consumable Commodities.” Since measuring people’s revenue is hard, many governments have chosen to tax their spending instead by taxing commodities. Some commodities are necessities, including food and whatever a society requires people to own in order to be treated with dignity (like clothing and shoes). All other commodities are luxuries.
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Taxes on necessities raise the price of subsistence, so wages must rise to compensate for the difference. Taxes on luxuries deter people who can’t afford those luxuries from consuming them. Accordingly, such taxes don’t hurt “the sober and industrious poor.” They do hurt “dissolute and disorderly” poor people, but such people don’t contribute much to society, as they have few children, most die, and the survivors are corrupt.
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Taxing necessities makes it harder for the poor to raise more children, which reduces the supply of labor. By increasing wages, taxes on necessities also cause rents to fall and the price of manufactured goods to rise. In this way, they hurt the rich and middle classes too. Britain heavily taxes five necessities: salt, leather, soap, candles, and coal. Despite their harmful effects, these taxes are also an easy source of substantial government revenue. (Instead of repealing them, Britain should focus on repealing the bounty on corn export first.) Other countries heavily tax bread and meat, but meat isn’t truly a necessity.
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To impose commodity taxes, the government can either charge consumers annually for their consumption or tax merchants before they sell their goods. The first system is better for expensive and long-lasting commodities, like coaches, gold and silver plate, and houses. The second system is better for perishable commodities. Proposals to tax everything through the first system are foolish, as such taxes would be unequal, heavy, and inconvenient. For instance, a licensing system for alcohol consumption would punish moderation and encourage drunkenness.
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Most of Britain’s commodity taxes are on luxuries. Some are excise duties (taxes on goods manufactured for domestic consumption) and some are customs duties (taxes on imports and exports). Originally, customs duties were supposed to tax merchants’ profits, so they were imposed on all goods. Later, Britain started assessing special duties on wool, cloth, leather, and wine, while taxing everything else by value.
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Then, Britain adopted the mercantile system. It replaced export duties with bounties and drawbacks, while creating different import duties for different commodities. There are no duties for materials of manufacture, while imports that would compete with domestic manufactured goods are completely prohibited. Most other goods face high import duties. These policies encourage smuggling and fraud, while decreasing Britain’s customs revenue. They encourage merchants to overstate exports and understate imports, which politicians appreciate because it makes Britain’s balance of trade look more favorable than it really is. The import duties are also extremely complicated and difficult to administer.
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It would be better to simplify the system by limiting import duties to a few, widely-consumed goods. For example, most of Britain’s customs revenue comes from European wine and brandy; American rum, tobacco, sugar, and coconuts; and Asian coffee, tea, spices, and porcelain. Import duties on other goods don't raise much revenue for the government—they just protect British manufacturers. If these duties are maintained, they should be designed to raise revenue, without reducing consumption or encouraging smuggling.
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The best way to fight smuggling is by administering the customs tax like an excise tax: customs officers should see and assess imported goods in common warehouses, so that they can ensure that merchants pay the right amount of tax. But this would only be practical if the system is limited to a few common goods—ideally the high-revenue goods listed above. By administering import taxes this way, maximizing revenues instead of protecting monopolies, and abandoning bounties and drawbacks, Britain could create a far simpler customs system without losing any revenue. Indeed, free trade for most goods would benefit merchants, manufacturers, and consumers. But Sir Robert Walpole failed when he tried to impose such a system for wine and tobacco.
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Taxes on imported luxuries mainly affect the wealthy and middle classes. Those on domestically-produced luxuries affect everyone. Since the vast majority of people are poor farmers, tradesmen, and small-time merchants, their expenses and wages account for most of society’s consumption and revenue. (They also earn much of the nation’s total profits and even some of its land rents.) But they should only be taxed for their luxury expenses, and never for their necessities.
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Britain doesn’t tax brewing and distilling for private consumption, so most wealthy families make their own beer (but not their own malt liquor). Malt is used in brewing, but easier to tax than beer and ale. Thus, it’s better to raise the malt tax, eliminate the beer and ale taxes, and lower the taxes on any other products containing malt. This would increase the government’s revenue while keeping spirits expensive (because they harm people’s health and morals) but lowering the price of beer and ale (which are “wholesome and invigorating”).
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This policy wouldn’t hurt malt producers, who will simply raise prices and pass along the tax burden, like any other manufacturer. Indeed, since total beer and ale taxes will fall, the new system will probably increase demand for malt and help maltsters in the long term. It certainly won’t lower rents and profits for barley land. Even if barley rents and profits fell, farmers would start growing something else, since barley land can easily be used to grow other crops. This wouldn’t apply to wine, as vineyard land can’t produce anything else of similar value, or sugar, which is already subject to a monopoly. The new rule would only hurt home brewers, who enjoy unfair advantages under the present system.
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There are many other ways to tax commodities, besides excise and customs duties. For instance, towns and provinces historically charged local tolls for transporting goods, but this obstructs domestic trade, which is essential for economic growth. Strategically-located countries charge transit duties on commodities that pass through their territories.
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Taxes on luxuries have many advantages. They fall entirely on the people who voluntarily consume luxury products. (However, people who live overseas can still avoid paying taxes, which is a difficult problem to solve.) They are built into the final commodity price, so consumers often don’t even realize they’re paying them. They are also certain and predictable, and they’re convenient for both the government and the consumer because they are paid at the point of sale.
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Luxury taxes’ main disadvantage is their inefficiency: they cost consumers much more than they earn in revenue for the government. First, administering customs duties is very expensive (although excise duties are cheaper). Second, luxury taxes reduce consumption and suppress industry by raising prices. Third, they encourage smuggling, which is an unproductive waste of capital and labor. Finally, luxury taxes force merchants to put up with visits from tax collectors, which are irritating and inconvenient—especially for excise duties.
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Britain’s tax system is still less burdensome than other countries’. Spain and Naples tax goods every time they are sold, which discourages serious domestic commerce. Britain’s uniform tax system makes domestic trade almost completely free, while France’s complex patchwork of province- and city-level tax laws is inefficient and expensive to administer. The systems in Milan and Parma are even more convoluted.
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It’s always cheaper and more reliable for the government to directly employ tax officers, rather than hiring tax farmers (private third-party tax collectors). These tax farmers lobby for harsher tax laws, establish monopolies over certain taxes, encourage smuggling, and pass on the cost of their exorbitant profits to consumers. For instance, in France, the five taxes administered by private collectors are full of waste, while the three managed by government collectors pass on nearly all their revenue to the crown.
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France should replace its unfair land tax (taille) and capitation tax with more revenue taxes (vingtièmes), particularly on the rich. It should unify its customs and excise duties to permit free domestic trade, and it should give all tax collection authority to government inspectors. Private interests will fight all three reforms. Britain earns 10 million pounds annually in tax revenue, but even with triple the population and much better land, France only earns 15 million. Holland’s high taxes have destroyed its manufacturing sector, but these may have been necessary to cover its high expenses for war and land reclamation. Besides, there are enough rich families in Holland to keep its economy going.
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