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Book 5, Chapter 2
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
In societies without much trade or manufacturing, wealthy people cannot buy luxuries, so they either buy necessities for others or hoard money. So does the sovereign. But in commercial societies, sovereigns and the wealthy buy luxury goods, often to excess. Instead of amassing treasure, such countries incur debts—especially during wars, which require massive and immediate spending.
In this final chapter of The Wealth of Nations, Smith will analyze how and why nations take on debt. For him, writing in the 18th century, this was a relatively new and troubling development. It enabled irresponsible leaders to spend far beyond their means, using the government to pursue their own short-term interests and forcing the people to pay for it in the long term.
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Merchants and manufacturers will lend this money to the sovereign because they generally have access to lots of capital. If they already trust the government to protect their property, they will certainly trust it to pay them back, which makes government debt a secure investment. As the sovereign usually borrows in times of crisis, it generally offers its creditors favorable terms, and those creditors can often sell its debt at a premium. Since the government knows that it will be easy to borrow, it has no need to save. This is why, by 1776, most European countries are heavily indebted.
The government’s incentives align closely with private creditors’. Namely, the government can easily get away with living off loans, and creditors see it as the most desirable borrower. Accordingly, the government gets access to practically unlimited credit, while its creditors get a very secure and profitable investment. But Smith clearly views this model as unsustainable, and he hopes to end his book with a clear warning about its perils.
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At first, governments offer unfunded debt, without any collateral. Later, they start dedicating certain funds to repay their debt, whether for a limited period of time or perpetually. For instance, the Bank of England loans the crown the expected value of land and malt taxes at the beginning of every year, and the crown pays it back with interest as it collects the taxes.
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This system began when the crown issued and repeatedly extended a series of temporary taxes in order to cover its interest payments between 1697 and 1710. The taxes became perpetual in 1711, then were consolidated into a fund to cover the crown’s interest payments in 1715 and 1717. Most European countries have done the same thing, repeatedly taking out temporary loans to pay their other loans before eventually resorting to “the more ruinous practice of perpetual funding.” Interest rates fell in the early 1700s, so Britain put all the money it saved in a new fund, which it spent taking out new debts.
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The crown also offers fixed-term and lifetime annuities, meaning it pays creditors their interest every year either for a certain number of years or until the creditor dies. Its long-term annuities, lasting 90 to 100 years, are financially equivalent to perpetual annuities. But they appear less attractive than perpetual annuities, so have become less common. Creditors particularly like tontines, or lifetime annuities organized in lots so that longer-surviving lenders receive higher payments. This is because people are overconfident, and everyone tends to assume they will live longer than average. Lifetime annuities are more common in France than England. This is because most of the English crown’s creditors are London merchants, who prefer perpetual annuities because they are easier to sell. But most of the French crown’s are wealthy farmers, tax collectors, and bachelors who care more about living luxuriously than passing on a fortune.
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If the people had to pay directly for war, they would hate and protest it, but perpetual funding allows governments to spread the cost of wars over many years. As a result, European city-dwellers even enjoy reading about wars in the newspapers and fantasizing about national glory. Their taxes don’t fall in peacetime—instead, the government constantly finds new ways to tax them. In fact, since Britain started using perpetual funding to pay for the war of 1688–1697, it has never even gotten close to paying off more debt during a period of peace than it borrowed in the previous war. Thus, Britain’s debt has consistently increased, and since the American colonies are just starting a new war, there is no reason to think it will stop.
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Some have defended England’s national debt by suggesting that this brought more capital into the country, but they are wrong. British creditors already had this capital—they just chose to lend it to the government, which wasted it on economically unproductive war expenses, instead of investing. Thus, while paying for public expenses with taxes merely diverts revenue from one economically unproductive activity to another, paying for these expenses with credit actually diverts capital from productive activities to unproductive ones.
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Paying for wars with debt prevents sudden tax increases during wartime. But such increases would cause the people to oppose war, so they would make wars shorter, less frequent, and less serious. In fact, Britain currently pays more in peacetime to service its old war debts than it would cost to directly fund a war through taxes.
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Since war debt shifts some of the nation’s land and capital from private to public ownership, it reduces landlords’ investment in land improvements and encourages capital owners to invest in other countries. Thus, every state that has funded itself with debt has become weaker: Genoa, Venice, Spain, France, and now Britain. The British tax system may be Europe’s best, but each new war will weaken it by forcing Britain to impose foolish and oppressive new taxes. As of 1776, these taxes haven't stopped the British economy from growing, but they may yet. Every country that accumulates massive debts will eventually go bankrupt.
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Some nations try to disguise these bankruptcies by redenominating their currencies, so that the government can pay its creditors less than it really owes. If Britain tries to do this, it will defraud countless innocent people out of their wealth and cause a disastrous loss of confidence in the government. Nations should openly declare bankruptcy rather than resorting to this evil “juggling trick.” Rome once did this by cutting a primary coin’s value by five-sixths (and then again by three-fourths). But this was a popular move because, in Rome, most debts were owed by the poor to the rich. Many nations have performed this trick secretly by debasing their currencies at the mint. This always causes popular outcry.
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Britain can only pay off its national debt by massively increasing the general revenue, massively decreasing expenses, or both. Smith’s proposals for reforming the land, house, customs, and excise taxes would help. But they wouldn’t be nearly enough. Taxing Ireland and the colonies would make a far bigger difference, but that would require giving all those territories representation in Parliament. Powerful interests at home would never accept that. But it’s worth explaining how this would work.
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Britain’s tax system has four parts: “the land-tax, the stamp-duties, and the different duties of customs and excise.” Landowners in Ireland, America, and the West Indies can certainly afford to pay the land-tax. Indeed, they can afford it more easily than British landowners can because church tithes consume a massive portion of British land rents, but there are no tithes in the New World. Extending the stamp-duties would be easy. Extending British customs rules to the colonies, while permitting free trade within the Empire, would hugely benefit everyone (and more than pay for itself). But excise rules would have to change, as the colonies produce different commodities from Britain, and in different ways. For instance, the rules for taxing English beer cannot apply to America, where every family brews its own. Yet excise taxes on sugar, rum, and tobacco would be easy to implement.
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In 1776, Britain currently collects 10 million pounds in tax revenue annually from eight million people. By taxing the two million people in Ireland and the three million in America and the West Indies at the same rate, it could earn another six and a quarter million pounds annually. One million would go to pay for the colonies’ government, and the rest would go to Britain’s debt, which it could completely pay off within a few years. Meanwhile, the new, fairer tax system would help the poor and fuel economic growth.
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Of course, not all people will produce the same tax revenue. The working masses are much poorer in Scotland than England, and they are even poorer in Ireland. The poorest white people in America and the West Indies are still much wealthier than the poor in England, while enslaved Black people in the colonies have the worst lives of all—even if they do consume commodities. Smuggling would be easier in America but simplifying the excise rules (and particularly taxing malt) would reduce it.
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The American colonies use paper money instead of gold and silver. This is not because they’re poor, but rather because they’re growing so fast that buying up gold and silver seems like a waste of capital. For foreign trade, Virginia and Maryland mainly pay in tobacco, while the northern colonies use gold and silver as necessary. The West Indian sugar colonies export far more to Britain than they import from it, but most of their landlords live in England and simply receive their rents in sugar and rum. The northern colonies’ gold and silver payments have been the most reliable, while payments from sugar colonies with significant uncultivated land (like Jamaica) have been the least reliable because planters prefer to invest in land improvements rather than paying their debts. So while America can afford to pay taxes in gold and silver, Britain could collect them in rude produce instead.
It’s only fair that America and Ireland should help pay for Britain’s debts, as they have Britain to thank for their religious freedom and military defense. By forming a union with Great Britain, Ireland could shake off its oppressive religious aristocracy, and the American colonies could avoid the violent internal divisions that are already tearing them apart.
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Lastly, not only do the East India Company’s territories rightly belong to the crown, but they are also much wealthier, more populous, and more fertile than Britain itself. The Company already overtaxes India, but by better administrating this tax system, Britain could pay off its debts.
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If Britain cannot increase its revenue, it has to reduce its expenses. Its tax collection system and military are both less expensive than its neighbors’ and couldn’t shrink much more. But its government and wars in America have been very costly, and they haven’t even turned the colonies into a proper taxpaying province. Even the colonial trade is a money-losing monopoly that hurts the people. Thus, if it really wants to cut costs, Great Britain should give up her colonies and “accommodate her future views and designs to the real mediocrity of her circumstances.”
