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An economic analysis of taxable capacity and its determining factors with special reference to the United States

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An economic analysis of taxable capacity and its determining factors with special reference to the United States

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Content AN ECONOMIC ANALYSIS OF TAXABLE CAPACITY AND ITS ,(■ DETERMINING FACTORS WITH SPECIAL REFERENCE TO THE UNITED STAGES by Ali Hezareh i i ' I A Thesis Presented to the FACULTY,OF,THE GRADUATE SCHOOL UNIVERSITY OF.SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree MASTER OF ARTS (Economics) August 1960 UMI Number: EP44781 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Published by ProQuest LLC (2014). Copyright in the Dissertation held by the Author. UMT Dissertation Publishing UMI EP44781 Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106- 1346 U N IVE R SITY O F S O U T H E R N C A L IF O R N IA GRADUATE SCHOOL UNIVERSITY PARK LOS ANGELES 7. CALIFORNIA Eg %l T h is thesis, w ritte n by ..... Ali.Hezgreh............ u n d e r the d ire c tio n o f his... .Thesis C o m m itte e , an d a p p ro v e d by a ll its m em bers, has been p re sented to an d accepted by the G ra du a te S choo l, in p a r tia l fu lfillm e n t o f requirem ents f o r the degree o f ............. .Master, .of..Arts............ Dean D a te ................. - A u g u s t - - - 1 - 9 6 0 C O M M t T T E E Chairman t TABLE OF CONTENTS CHAPTER PAGE . ' ? ? i t I. INTRODUCTION . . . . ..................... 1 The problem........................... 6 Statement of the problem............. 6 Purpose of the study................... . . 10 Limits of the study......... 11 Definition of terms used.................... 13 Review of the literature............... 15 Organization of the remainder of the thesis............... 17 II. THE NATURE OF TAXABLE CAPACITY........... 19 Meaning of taxable capacity ......... 20 The determining factors of taxable capacity............................. 24 The level and distribution of national income............................. 24 The scope and nature of public expenditures....................... 29 Nature and methods of taxation....... 35 Present state of the economic system .... 39 Type of economic system .......... 41 Attitudes of the people........... 42 • * n iii CHAPTER PAGE III. THE FRAMEWORK OF TAXABLE CAPACITY: GOVERNMENT EXPENDITURES AND TAXATION......... 44 The role and development of public finance in the United States...................... 45 The scope and nature of public expenditures ............................ 46 The growth of public expenditures .... 47 The distribution of public expenditures. . 49 The scope and nature of taxation ...... 55 The growth of tax revenue collections . . 57 The nature and the relative contributions of different taxes.................... 58 The net economic effects of taxes and expenditures .............................. 65 The net effects on the allocation of resources.............................. 66 The net effects on the level of national income ........................ 72 The net effects on the distribution of income . ............................. 76 The net effects on economic growth......... 80 IV. THE PROBLEMS OF TAXABLE CAPACITY OF THE UNITED STATES........................ . 84 A few pages of history on taxable capacity . . 86 iv CHAPTER PAGE An evaluation of Clark* s thesis.......... 94 Conclusions to Clark’s thesis ............. 108 The taxable capacity to the United States . . 113 A note on the taxable capacity of under-developed economies ................. 117 V. CONCLUSION........................... 126 BIBLIOGRAPHY ........................... 132 LIST OF TABLES TABLE PAGE I. American Government Expenditures and National Income, Selected Calendar Years 1929-1957 . . 48 II. Functional Distribution of American Government Budget Expenditures, Fiscal Year 1957 .... 52 III. The Functional Distribution of Federal Expenditures, 1957 54 IV. Tax Receipts and National Income, Calendar Years 1929-1957 59 V. Federal Tax Collections by Source, Selected Fiscal Years 1929-1958 . . ......... 61 VI. State Tax Collections by Source, Selected Fiscal Years 1932-1958 62 VII. Local Tax Collections by Source, Selected Fiscal Years 1932-1957 64 LIST OF FIGURES FIGURE PAGE 1. The Relationship of Taxation to the Operation \ of an Economic System......................... 8 vi CHAPTER I INTRODUCTION The days of “laissez-faire, laissez passer,” or the ”be quiet” attitude government, for good or bad, are gone. The last fifty years have witnessed a tremendous growth in government responsibilities, expenditures, revenues, and debt. Even in the essentially capitalistic, free- enterprise economies, the scope of government action beyond the regulatory duties prescribed by ”laissez-faire” phi losophy has grown steadily and rapidly. The present attitude toward public finance is the product of a strange marriage of three major philosophies. The first philosophy was advanced by the mercantilists of the sixteenth to eighteenth centuries who emphasized the importance of the government economic activities. They argued that public policy should be so formulated as to expand exports, to reduce imports, to establish new industries, and to induce other economic activities which will add to the "riches” of the country. Public direction, even for the businessman who was considered "the Steward of the Kingdom*s Stock,” was the crux of the mercantilism.*- ■^Thomas Mun, England*s Treasure by Foreign Trade (New York: The MacmillanCompany, 1928), p. 1. It roast be pointed, however, that it was the cameralists, the German mercantilists, who specifically advocated the 2 use of public finance to achieve their goals. The influential nineteenth-century English liberals held the second view on public finance. The classical economists did not deny the importance of government activities; but since the classical school regarded public finance as an outside, non-economic factor and disturbing to the functioning of a self-regulatory economy, a great number of classical economists insisted that the function of state should be kept at a minimum. The writings of the classical school made some valuable contributions to the analysis of public finance, particularly to that of the shifting and incidence of taxation; yet ". . .by failing to give adequate attention to government transactions classical doctrine forced the development of a special science of public finance.” The third point of view was advanced by a group of writers, who argued that capitalism ”... must and will give way to socialism wherein all production and distribu tion will be controlled directly by the state, for the O *See Eli F. Heckscher, Mercantilism (London: G. Allen and Unwin Company, 1935), pp. £35-42. ^Gerhard Colm, "Why Public Finance?" National Tax Journal. I (September, 1948), 195. benefit of the masses. In spite of these opposing views toward the role of government, the philosophy of "laissez-faire” was quite predominant in the latter part of the eighteenth and in the nineteenth centuries. A great number of the classical economists regarded public finance as an external, non economic factor, and disturbing to the operation of the private economy. Having considered public expenditure to be non-productive and taxation as a means to raise revenue for the "regular” expenditures of government, a great number of the classical writers insisted that govern ment economic activities should be kept at a minimum. The great events which have taken place during the past fifty years have changed our attitudes toward public finance. Today, a great number of people have come to realize the limitations and shortcomings of the self- regulatory "market principle," and have acknowledged the need for the supplementary and corrective actions by government. The idea of "laissez-faire" was, perhaps, the logical outcome of its advocates* assumptions. The passive role which the classical school assigned to government 4 Mary J. Bowman and George L. Bach, Economic Analysis and Public Policy (second ed.: New York: Prentice- Hall, Inc., 1949), p. 687. might have been justified in view of the broad economic and social objectives of the eighteenth and nineteenth cen turies. Times have changed and so have the conditions on which the philosophy of "laissez-faire” was based. Under the present economic and social conditions, .. . a democratic society that intends to serve humanitarian goals can no longer rely on the hope that the economic mechanism by itself, without governmental participation, will secure the realization of its ideals.5 The new, positive economic and social roles which governments have assumed in recent years are the product of the economic and social goals and problems of the twentieth century. Among the more important factors that have been responsible for the expansion of public expenditures, taxes, and debts are: (1) the rise in the general level of prices, (2) the expansion of collective wants, (3) indus trialization and economic concentration, (4) growth in population and urbanization, (5) wars and the needs of national defense, (6) depressions and economic instability and the need for social planning, and (7) the problems of underdeveloped economies and the need for social planning.^ ^Gerhard Colm, "Is Economic Planning Compatible with Democracy?” Essays in Public Finance and Fiscal Policy (New York: Oxford University Press, 1955), p. 294-. ^William H. Anderson, Taxation and the American Economy (New York: Prentice-Hall, Inc., 1951), p. 5. 5 Thus, at the present time, both economists and people in general have come to recognize the true signi ficance and strategic role of the public economy. The economic and social problems of today require that "market principle" should be supplemented and strengthened by state activities. The cooperation of the private sector with the public sector of the economy is of vital importance if democracy is to be preserved and economic and social in justices are to be minimized. In the preceding few pages this writer has en deavored to present an over-all and brief discussion of the development of public finance and the new economic role of government. It was pointed out that the great events which have taken place in the last few decades have empha sized the need for a more positive role by government and the public economy. The ever-pressing problems of economic development with which a large number of countries are faced have necessitated an even more vigorous role by government to further the process of economic growth. The recent changes and developments in the public attitude toward government have manifested themselves in a growing demand for public functions. I. THE PROBLEM 6 Statement of the Problem The growing public functions and expenditures in recent years have made it necessary to give more attention to several aspects of taxation as a basic means of financing governmental outlays.^ Since these aspects of taxation are greatly relevant to the nature of this study, they deserve brief comment. The development of a tax system to yield adequate revenues to finance the "necessary" and "essential" public expenditures must receive primary consideration. Every effort must be made to devise a tax system that produces enough revenues to finance various government undertakings. If the tax system does not yield adequate revenues, then . . . the government will be either forced to suspend its activities below the level of maximum social benefit, or it will be forced to borrow or print money to finance these activities— both of which actions are undesirable as a consistent policy.8 Another phase of taxation which must be considered \ is its economic effects. The nature and the impact of 7 Although it is fully recognized that government / programs could be financed through several means, we are basically concerned with taxation in this study. There fore, other means of financing government expenditures will not be discussed. 8 Anderson, op. cit.. p. 52. modem taxes have unmasked another quality of taxation besides that of being just a means of raising revenues to finance government outlays. Experts seem to agree that modem taxation can be of strategic, economic significance in the functioning of an economy. It is argued that modem taxation, through its effects on the "basic economic functions" (working, saving, investing, and consuming), can exert a great deal of influence on the levels of produc tion, employment, and income. The relationship of modem taxation to the operation of an economic system is further illustrated in Figure 1. Figure 1 shows the manner by which taxation can affect the functioning of the economic system. Through its impacts on the "basic economic functions," modem taxation can cast a great deal of influence on the levels of produc tion, income, and employment. Taxation, moreover, can impose its effects on the economy in a macroscopic fashion and more directly. The processes of draining out a portion of national income from the private sector by taxation, and then putting these funds back in the economy through public expenditures affect the economic system more directly by influencing the allocation of resources, price levels, the level of national income, the distribution of national income, economic stability, and economic growth. In short, taxation, or a combination of tax and expenditure policies, FIGURE / THE RELATIONSHIP O r TA U T I ON t o t h e o p e r a t io n o r AN ECONOMIC SYSTEM i P / o p e n s t t y fo Work I . p r o p e n s i t y t o S & v c 2 . A b i l i t y t o w o r k ^ . A b i l i t y t o S i V e l.ft'open sltyli /n /ts t JPropo n sitylb Como me < 2 . Ability ! b Invest 2j\k>\\\\y to Consome. Tot*I SavinG C O N S U M IN G WORKING TA X A TIO N F u n c t/ on/n g o f econom ic system TOTAL PRODUCTION. IN C O M E. AND EMPLOYMENT NOTE: THIS FY6URE IS REPRODUCED FROM THE LECTURES /N S E MINA R IN 7 M THEORY AND LITERATURE CONDUCTED BY PR O - FESOR WILLIA M H . A N D E R S O N . UNIVERSITY OP SOUTHERN CALIFORNIA, D EC EM BE R. tS 5 7 P E R F U S I O N IS S E C U R E D - could promote and direct: (1) economic stability, (2) eco nomic growth, and (3) equitable distribution of income.^ The foregoing discussion, therefore, points out that because of a tremendous increase in the responsibilities of government, particularly in the under-developed areas where government is increasingly assigned a far more positive role in the process of economic development, the need for larger revenues has become great. It further shows that taxation could be a very useful and effective device to promote various objectives of national economic policy. Tax policy, if scientifically formulated and effectively administrated, can directly or indirectly contribute to the better functioning of the economic system. But, tax policy i is a tool, and like other tools, if carried beyond its limits, can become a dangerous instrument and may impair the operation of the economic system. The extensive need for revenue, on the one hand, and the fact that taxation could become a dangerous device, on the other hand, have made it necessary that more attention be given to the limits of taxation and taxable capacity. While authorities seem to agree that taxation is a very effective economic tool of national economic policy, few would doubt, however, that if taxation is used beyond ^Roy Blough, The Federal Taxing Process (New York: Prentice-Hall, Inc., 1952), pp. 466-73. its limits, it could hamper the functioning of the economy. This brings into focus the facts that there are many economic, psychological, political, and administrative limits to the use of taxation as an economic instrument which must be considered along with its other aspects. In the light of these considerations, ”... the task of adjusting the tax load to the economy in the most bearable manner . . ."10 has become not only very diffi cult, but also of utmost importance. The limits of taxable capacity become increasingly significant where the private- enterprise system and democratic institutions are to be i preserved, for ’ ’the power to tax involves the power to - destroy. ”x Purpose of the Study The purpose of this study is to examine and analyze taxable capacity and its determining and limiting factors in highly-developed economies. The relative nature of taxable capacity and its determining factors coupled with vast economic, social, and political differences of differ ent countries suggest that a comparative approach be employed. Yet, the lack of adequate and accurate data l^Anderson, op. cit., p. 520. • ^McCulloch v. Maryland. 4 Wheaton 316 (1819). Cited by Anderson, op. cit.. p. 20. 11 on many under-developed countries forced this thesis to deal with the taxable capacity of highly-developed coun tries. No mathematical guide as to what level of taxation is most appropriate for any particular country was sought. Yet, an attempt was made to lay down the basic principles of taxable capacity, and to establish at least a conceptual or theoretical guide for determining the optimum level of taxation. A conceptual norm was sought within which later studies may establish more definite and precise guides. Furthermore, while this study was largely concerned with the limits of taxable capacity, yet the problems of tax limits and capacity cannot be analyzed apart from the value and effectiveness of taxation as an economic control or promotion device. Therefore, an attempt was made to examine the limits as well as the effectiveness of taxation as a tool of national economic policy. Limits of the Study This study is limited to the treatment of the taxable capacity of those economies which are essentially ' organized on Private-enterprise Principles. It is fully recognized that the problems of taxable capacity are not confined to the free-enterprise countries; however, to bring the subject-matter of this thesis within reasonable boundary and the firm conviction that taxable capacity 12 is relatively less significant in ntotalitarian” societies, this thesis is primarily devoted to the free-enterprise countries. The nature of the subject-matter and the lack of adequate and accurate data have forced this discussion to be more analytical than empirical. An analytical approach to the problems of taxable capacity, although quite import ant and useful, may result in a number of untested general izations. However, this is not believed to have damaged the study substantially, for the nature and complexity of taxable capacity often force one to be content with a good deal less than final and definite answers. Moreover, this study does not attempt to include minute case studies of taxable capacity of specific coun tries. In fact, the United States is the only country whose taxable capacity is extensively analyzed. Occasional references, however, are made to other countries in order to support and strengthen the analysis. Finally, taxable capacity depends, among other factors, on the present state of economic conditions : (depression, recession, prosperity, or inflationary boom) and the prevailing international condition (peace, "quasi" war or war). To keep the thesis within the bounds of simplicity and comprehension, it is assumed that the present state of economic conditions is prosperity and 13 i the prevailing international condition is peace or a state of "quasi” war. II. DEFINITION OF TERMS USED There are certain terms and concepts, highly essen tial to our analysis, which must be defined. These con cepts will be used in the thesis as they are defined at this stage. Economic development. Economic growth might be defined as ”. . . a sustained rise in per capita real in come."^ * Economic limits. There are several economic limits ,of taxation of which the most important two will be defined here. One economic limit may be defined as the point ". . . beyond which a further increase in rate does not result in larger revenues, or perhaps . . . an increase in 13 rate results in smaller revenues." Another economic limit is the point "... beyond which a tax increase, although it produced revenue, would not actually be anti- inflationary ." ^ ■ 12C. Lowell Harriss, The American Economy (Homewood, Illinois: Richard D. Irwin, Inc., 1956), p. 7347 ■^Blough, on. cit.. p. 229. ^Ibid., pp. 230-31. 14 Political limit. ". . . the point beyond which it is not possible to secure further tax increases because of political resistance. Private-enterprise capitalism. "... that system of economic organization in which free enterprise, competi tion [some governmental controls and economic activities], 16 and the private ownership of property generally prevail." Psychological limit. "... the point beyond which people refuse to face up to the responsibility and the necessity of paying taxes. Tax burden. ". . . the weight or impact of taxes on 18 the income of the individual or the people as a whole." Taxable capacity. The tax load which an economic system can economically, psychologically, and politically bear without greatly hampering the operation of that 14 system. ^Ibid.. p. 231. ^Raymond T. Bye, Principles of Economics (fifth ed.; New York: Appleton-Century-Crofts, Inc., 1956), p. 663. ■^Blough, loc. cit. •^Lewis H. Kimmel, "Our Tax Burdens and Taxable Capacity," The Annals of the American Academy of Political ana Social Science. 266 (November. 1949), 152. ■^For a further elaboration of this definition see Chapter II. 15 Under-developed economy. "... is one which on the average affords its inhabitants an end product of consump tion and material well-being appreciably inferior to that 20 provided by the economies of the developed countries.' Or, an under-developed economy is one with comparatively low per capita real income, but has the potentiality for improvement. III. REVIEW OF THE LITERATURE Much has been written on the subject of taxable capacity. However, publications regarding the subject of taxable capacity analysis are limited almost entirely to that of the United States. References to the taxable capacity of other countries have been more or less inci dental. The following references constitute by no means an exhaustive treatment of all the literature on the topic of taxable capacity. What is attempted here is to list major sources that were used and a few important sources in which additional information may be found. Kimmel’s Taxes and Economic Incentives,^ Stamp’s ^Norman S. Buchanan and Howard S. Ellis, Approaches to Economic Development (New York: The Twentieth Century Fund, 1955), pp. 3-4. 21 Lewis H. Kimmel, Taxes and Economic Incentives '(Washington, D.C.: The Brookings Institution, 1950). 16 Wealth and Taxable Capacity,^2 Bastable * s Public Finance.^ Dalton* s Principles of Public Finance,^ and Blough* s 25 The Federal Taxing Process were found to contain valuable information on the subject of taxable capacity. Moreover, in recent years several articles regarding taxable capacity have appeared in professional journals. Clark*s "Public Finance and Changes in the Value of 26 27 Money," Goode*s "An Economic Limit on Taxes,” and 28 Kimmel*s "Our Tax Burdens and Taxable Capacity," are a few outstanding ones. Finally, the chief sources of statistical informa tion have been Statistical Abstract of the United States, ^Sir Josiah Stamp, Wealth and Taxable Capacity (London: P. S. King and Son, 1922). C. F. Bastable, Public Finance (London: Macmillan and Co., 1892). ^^Hugh Dalton, Principles of Public Finance (London: Routledge and Kegan Paul, 1946). ^Blough, op. cit., pp. 229-33. ^Colin Clark, "Public Finance and Changes in the Value of Money,” Economic Journal, LV (December, 1945), 371-89; "The Danger Point in Taxes," Harper*s Magazine (December, 1950), 67-69. 27 *7Richard Goode, "An Economic Limit on Taxes: Some Recent Discussions," National Tax Journal, V (September, 1952), 227-33. 2®Kimmel, "Our Tax Burdens and Taxable Capacity," pp. 152-60. 17 Survey of Current Business, and several of the United Nations publications. A number of the United Nations publications, which have dealt with taxes and fiscal poli cies in the under-developed countries, have been thoroughly consulted in the related sections. IV. ORGANIZATION OF THE REMAINDER OF THE THESIS Chapter II, which immediately follows, is devoted to an analytical treatment of the scope and the nature of taxable capacity and its determining and limiting factors. A rather broad approach is employed in this chapter to examine the problems of tax limits and to lay down the basic principles and foundations of taxable capacity. An attempt is made to establish a framework of analysis for taxable capacity in Chapter III. More spe cifically, this chapter is concerned with the development of public expenditures and taxation in the United States. Moreover, an attempt is made to examine the economic effects of public activities on various economic activi ties, namely, the ’ ’ basic economic incentives," the size and the distribution of national income, the allocation of resources, and economic- growth. Chapter IV deals more specifically with the problems of tax limits and taxable capacity. After analyzing the controversial question of taxable capacity, a careful 18 examination of the United States taxable capacity is made. A short note on the taxable capacity of the under-developed countries also appears in this chapter. The summary of previous chapters and the conclusions of the study appear in Chapter V. i CHAPTER II THE NATURE OF TAXABLE CAPACITY The rapid expansion of tax supported public functions and expenditures in recent years has raised a fundamental question, namely, how high can taxes rise? Or, what por tion of national income can be absorbed by taxation without seriously impairing the operation of a private-enterprise economy? These questions require a close examination of taxable capacity. The concept of taxable capacity has been subject to many different interpretations. While some economists have emphasized the limits of taxable capacity and have attempted to set a limit on the taxable capacity of an economy, others have regarded such capacity as practically unlimited. The controversies over the nature of taxable capacity, therefore, suggest that the concept of taxable capacity should be clearly defined and thoroughly analyzed. This chapter will be mainly concerned with: (1) a .close examination of some of the definitions of taxable i capacity, (2) an attempt to redefine the concept of taxable capacity so as to make it more consistent with the analysis of taxable capacity as used in this study, and (3) an analytical discussion of the determining and limiting 19 i 20 I 1 factors of taxable capacity. I. MEANING OF TAXABLE CAPACITY The concept of taxable capacity has already been defined in Chapter I. The unsatisfactory character of the generally-accepted definitions of taxable capacity, at least for the purpose of this study, however, necessitates a more thorough discussion and redefinition of the concept of taxable capacity. There are many economic, psychological, and politi cal limits to the use of taxation as a tool of national economic policy. A close examination of some of the generally-accepted concepts of taxable capacity, however, reveals that almost all definitions are essentially formu lated around the economic limits of taxation. Lewis H. Kirnmel, for example, defines the taxable capacity of a private-enterprise economy ”. . . as the capacity to raise revenues without extreme interference with productive activity [italics not in original] and the operation of the economy.”* " While Kirnmel is quite aware of the fact that taxable capacity depends on economic, and noneconomic circumstances **Lewis H. Kirnmel, Taxes and Economic Incentives (Washington, D.C.: The Brookings Institution, 1950), p. 5. 21 and factors,2 his definition of taxable capacity seems to be basically concerned with the economic aspects of taxa tion. In regard to the above definition, the point must be made that the ability and the willingness of an economy to bear a given tax load— or the ability of government to raise a certain amount of revenue through taxation— are affected not only by economic factors, but also by other considerations. An addition to the existing tax load which may not seriously impair the economic productivity of tax payers, could result in unfavorable political and psycho logical attitudes toward the tax increase in particular and the whole tax system in general. These unfavorable and hostile reactions may, in turn, manifest themselves in political resistance, tax evasion, and so on. As the result of the political and psychological limits of taxa tion, therefore, it is conceivable that the ability of government to raise revenue through taxation might be held to a point well below that indicated by economic limits. In light of these considerations, therefore, Kirnmel*s definition of taxable capacity seems to be some what inadequate and obscure. William H. Anderson defines taxable capacity as 2Ibid., p. 6. ". . . the tax burden [italics not in original] which an economic system can bear without seriously impairing the operation of that system.While this definition is superior and clearer than our first definition, it is also formulated basically on the economic limits of taxation. So long as the tax burden refers to ”. . . the impact of taxes on the income [italics not in original] of the indi vidual or people . . . , then it is clear that we cannot use the concept of tax burden in this limited sense in defining taxable capacity. The concept of tax burden, if used in defining taxable capacity, should not only include the impact of taxes on the income of the individual or the people as a whole, but also its effects on the psycho political attitude of taxpayers. The task of formulating a definition of taxable capacity which would clearly embrace all kinds of tax limits is a difficult one. In view of the preceding con siderations, however, taxable capacity might be defined as the tax load which an economic system can economically, psychologically, and politically bear without extremely j impairing the operation of that system. t o William H. Anderson, Taxation and the American Economy (New York: Prentice-Hall, Inc., 1951), pp. 568-69. ^Lewis H. Kimmel, ’ ’Our Tax Burdens and Taxable Capacity,” The Annals of the American Academy of Political and Social Science, 266 (November, 1949), 152. 23 The purpose of redefining the concept of taxable capacity is neither to discard other definitions as totally uncongenial^ nor to under-emphasize the economic limits of taxation. Nevertheless; a lucid definition of taxable capacity is believed to be a fundamental step toward a better understanding of the nature and scope of tax limits and capacity. Our preceding discussion indicated that the ability of government to raise revenues through taxation is limited. No academic inquiry or empirical study has thus far provided us with an objective mechanism by which we could determine the precise point at which a tax load becomes unbearable. This is primarily due to the fact that the concept of taxable capacity is relative, and depends upon a set of economic and non-economic factors which vary from place to place, from time to time, and from one eco nomic system to another.3 That is why one observer has £ declared that ”... absolute taxable capacity is a myth." Although taxable capacity cannot be determined and It should be mentioned that both our definition of taxable capacity and its determining factors are essen tially valid for the private-enterprise economic systems. The definition and the determining factors of taxable capacity should be substantially changed if one is dealing with a socialistic or a communistic economy. i £ Hugh Dalton, Principles of Public Finance (London: Routledge and Kegan Paul, 1948), p. 169. 24 measured precisely, there are various factors which deter mine taxable capacity while not with mathematical preci sion, yet with reasonable certainty. II. THE DETERMINING FACTORS OF TAXABLE CAPACITY There are a number of factors which in one way or another, influence and determine the taxable capacity of an economy. Before examining these factors closely, it should be re-emphasized that these factors are not fixed and absolute at all times and in all places. Some of these determining factors of taxable capacity are presented below. The Level and Distribution of National Income It is generally agreed that the size of national income, plus its composition and distribution is a major determinant of taxable capacity. Some economists, however, argue that it is the ’ ’real" national income which is of great significance in determining taxable capacity, because it is the "real” national income which measures the "real" capacity of an economy to bear a tax load in the long-run. : Other writers, however, point out that so long as taxable 'capacity is influenced by the psychological attitude of people toward taxes which in turn could be influenced by their "money" incomes, then taxable capacity could be influenced by the level of "money" national income. 25 It appears that there is some truth in both arguments depending upon our definition of taxable capacity (whether defined in real term or monetary term), the relative im portance of the psychological and economic limits of taxa tion, and the relative importance of ’ ’ money illusion" on people’s attitude toward taxation. Hence, the level of national income plus its com position and distribution should be regarded of great importance in determining taxable capacity. Special im portance, however, should be attached to that level of national income which is above two margins: (1) The first margin refers to that part of the people’s income which is . . to cover basic needs for foods, clothing, shelter, and reasonable pleasures.’ ’^ That is to say, that there is a strong relation between taxable capacity and that portion of national income which ”... is left after providing for essential private consumption. O . . ." What constitutes basic consumption-needs is not very clear because of its dependence on the standard of living which is an ever-changing phenomenon itself. •However, by essential consumption is meant a level of ^Anderson, op. cit., p. 569. 8 Kirnmel, Taxes and Economic Incentives, p. 7. See also, Ursula K. Hicks. Public Finance (London: Pitman Publishing Company, 1947), p. 17. 26 i ' i consumption which is necessary to maintain "productive efficiency." (2) The second margin which should receive special consideration is that part of national income which must be apportioned to investment in order to sustain and pursue an adequate degree of economic growth. The size of the in vestment margin depends on a number of conditions, namely, the nature of public expenditures, the rate of saving and capital formation in the country, the intended rate of economic growth, the type of economic system, and so forth. In the light of these considerations, one can easily appreciate that there exists a direct relation between the size of national income and the taxable capacity. This relationship, however, is stronger between taxable capacity and that portion of national income which is left after providing for basic consumption-needs and investment expenditures, because it is this "left-over" part of national income which could be made available for taxation. Although there exists a direct relation between the size of national income and the taxable capacity, the exact i relationship is controversial and must remain conjectural. One authority, however, theorizes that "... when real national income rises, taxable capacity tends to increase more than proportionately."7 In order to substantiate ^Ibid., p. 8. this statement, an illustration is given by Lewis H. Kirnmel in which the average annual requirement for essential private consumption is $700 per capita. A rise in per capita real income, from $1,000 to $1,200, or by one-fifth, it is argued, would mean a two-third increase in the margin above basic private c o n s u m p t i o n . ^ Although there might be some truth in this view, it seems to be founded on a number of non-plausible assump tions which deserve brief comments. First, it assumes that that portion of national income which is left after pro viding for basic private consumption can be taxed away without hampering the functioning of the economic system. This is an invalid assumption, specially in the private- enterprise economies where the great bulk of investment— which is one of the major factors of economic development— is done by the private sector. Secondly, it presumes that the change in the national income is neither the result of, nor is followed by a change in the level of consumption or/and investment. That is to say, that consumption and investment are not the function of income or vice versa. This assumption is also incorrect and warrants no further elaboration. I The manner in which national income is distributed 10Ibid. 28 influences taxable capacity. It is commonly held that a country with a more equal distribution of income enjoys a greater taxable capacity than one in which there is con siderable inequality in distribution of income. A more equal distribution of income not only enables a great majority of the lower-income groups to satisfy their basic consumption needs and still have some income left for the purpose of tax payments, but also creates a more favorable attitude toward taxes. Kirnmel, however, is of the opinion that: Taxable capacity is naturally greater in a nation in which there is considerable inequality among incomes than in one in which they are more nearly uniform. This follows not only because the margin of income above essential consumption requirements which can be tapped by taxes is larger in the case of the higher incomes. An important factor is that, as this margin rises, taxpaying capacity increases more than propor tionately. While there is some theoretical validity to this statement, it suffers from several basic difficulties. In the first place, it approaches the problem from a micro point of view. It is true that the taxable capacity of a few might be greater in a country with an unequal distribu tion of income than one in which income is more equally ! ^ Ibid.. pp. 8-9. If this view is held to be valid, then the inference can be made that, other things being equal, almost all of the under-developed countries, in which there is a considerable inequality in the distribu tion of income, enjoy a higher taxable capacity than the developed economies. This view, however, seems to hold very few supporters. distributed; but this does not necessarily mean a higher taxable capacity for the whole economy. In the second place, as indicated before, that part of national income which is left after providing for essential private con sumption cannot be regarded as being totally available for the purpose of taxation. For a careful allocation of this segment of national income among investment, other private consumption than basic, and public services is an essen tial condition of economic growth. Finally, Kirnmel over looks the fact that a considerable inequality in the distribution of income may force a large number of the lower-income groups to forego some of their essential consumption-needs. Other things being equal, this may, in turn, cause a lower human productivity, national income, and taxable capacity. Therefore, this thesis will hold the view that a more uniform distribution of income, other things being equal, tends to enhance the capacity of government to tax without seriously impairing the operation of the economy. The Scone and Nature of Public Expenditures < The quantity and quality of public expenditures influence taxable capacity. The effects of the volume of public outlays on production, the level and the distribu tion of national income, and the "basic economic incen tives" and thereby indirectly on taxable capacity need no extensive examination here because a great deal of time will be devoted to it later on. The nature of public expenditures— or the uses which are being made of public outlays— deserves brief comments. It is argued that the "necessary” or "desirable" public expenditures not only contribute to the "well-being" of the nation, but also complement and stimulate the "productive" functioning of the private sector and thereby could enhance taxable capacity. But, if public funds are spent "unnecessarily" or inefficiently, then they may affect "economic incen tives" and production adversely and thereby lower taxable capacity. That is to say that if public expenditures are considered "necessary" or "essential," they not only serve their intended purposes and satisfy human wants, but also may indirectly stimulate the "productive" functioning of the private sector. On the other hand, if public expendi tures are considered "unnecessary" or are inefficiently used, then they not only withdraw resources (real or monetary depending on the nature of expenditures) from the private use, but may also exert adverse effects on the "basic economic incentives" and thereby lower the economic ability of people to pay taxes. "Unnecessary" or ineffi- i 'cient public outlays may further create an unfavorable i attitude toward public activities and taxation. The unsatisfactory nature of the terms of "desirable 31 vs. undesirable,” "essential vs. unessential,” "necessary vs. unnecessary,” or "productive vs. unproductive" which have often been used with respect to public expenditures necessitates a brief examination of these terms. The controversy over what constitutes "necessary" or "desirable" public expenditures has a long history and still must remain the subject of query and debate. Econo mists, however, have employed the terms of "productive" and "unproductive" with respect to public expenditures. Although there exists a great deal of confusion as to what is meant by the term "productive," the common sense view today is of "relative productivity," or the "altemative- use" approach. In spite of the inadequate nature of the theory of "comparative social maximum benefit"— a yardstick which economists have employed to measure the "relative productivity" or the "relative unproductivity" of public expenditures— plus the fact that expenditures which mainly serve social or political purposes are not easily measured by any economic yardstick, a brief examination of different interpretations of the "productivity" of public expendi tures is in order. First, some economists argue that the public expenditures for "self-liquidating" projects are "produc tive." They argue that so long as these services can be sold, then it means that there is a need for them and they should be considered "necessary" expenditures and services. 32 This does not, however, prove that there is less need for ’ ’non-liquidating" projects. The second criterion of "productivity” is a broader one in so far as it includes not only the "self-liquidating" expenditures, but also those expenditures which indirectly increase government revenues. Expenditures on highway construction serve as a good example in so far as these expenditures may increase the amount of fuel tax and so forth. This criterion also fails to indicate which public activities are the most needed and necessary ones. Finally, some economists con sider public expenditures to be "productive" if they increase the productivity of the nation. Public expendi tures for education, for example, are argued to be "pro ductive" since education tends to affect the quality of labor favorably which in turn could increase labor produc tivity. Military expenditures, on the other hand, are considered to be "nonproductive,” since these expenditures do not seem to increase the productivity of the nation. It must be pointed out, however, that this "nonproduc tivity” by itself does not seem to be a strong argument against these expenditures, if their "non-economic” purposes are considered very important.^ •^Gerhard Colm, "Theory of Public Expenditures,” The Annals of the American Academy of Political and Social ,Science. 83 (January, 1946), 1-11. See also, Harvey W. Peck, "The General Theory of Public Expenditures,” View points on Public Finance, ed. by Harold M. Groves (New York: Henry Holt and Company, 1947), pp. 550-53. It seems clear, therefore, that the often-used terms of "desirable vs. undesirable,” "necessary vs. unneces sary,” and "productive vs. unproductive" public expendi tures are not very easy to define and clarify. What constitutes "desirable vs. undesirable," or "necessary vs. unnecessary" public expenditures depends on one*s philoso phy as to what should be the proper role of government in an economy, the strength of social or political purposes of government expenditures, the nature of public projects (whether they are of "additive" kind like undertaking new projects which the private sector for one reason or another has not undertaken, or whether they are of "transforming" type like establishing public schools which may take the place of private schools), and many other factors. In spite of these difficulties, however, this writer thinks it is quite right to talk of "productive" or "unproductive" public expenditures in two broad ways. First, we may speak of "unproductive" public expenditures, if these resources could have been used more "productively" or efficiently by the private sector. Secondly, we can speak of "unproductive” public outlays, if their alterna tive use for other public projects would have been more "productive." The keynote here, of course, is "relative productivity" or the alternative use of resources. If various services can be performed more economically or 34 efficiently through government than through private pro ducers, then we may say public expenditures are relatively productive. On the other hand, if the private sector could have used these resources more effectively or economically than government, then we may speak of ’ ’ unproductive” public expenditures. It must be re-emphasized, however, that we ; are speaking of ’ ’economic productivity” which cannot be considered the only criterion of public activities, for there are other criteria which one has to consider in determining the best scope of public activities. We may sum up our discussion by indicating that ’ ’necessary,” ’ ’desirable,” or ’ ’productive” public expendi tures not only contribute to the ’ ’ well-being” of the nation, but also complement and stimulate the "productive” functioning of the private sector and thereby may enhance taxable capacity. "Essential," "desirable,” or "produc tive" public spending may contribute a great deal to the functioning of the over-all economy and total welfare in so far as: (1) they are investments which may increase eco nomic "productivity," (2) they satisfy human wants, and (3) they provide employment and purchasing power, j "Unnecessary," "undesirable," or "unproductive" public expenditures, on the other hand, may prove detr imental to the "basic economic incentives" and operation of the economy in so far as they may withdraw resources from 35 private uses which could have been utilized more "pro ductively” and efficiently by private producers, or they could have been used more efficiently or economically, had they been used for other public projects. Nature and Methods of Taxation In analyzing taxable capacity and tax limits, one cannot disregard the great importance of . . the nature of the tax structure, the kinds and diversity of the taxes, and the intelligence with which they are applied in the TO economic system. The taxing power of government is often subject to many constitutional and statutory limitations.^ These limitations, which constitute the very framework within which taxes are levied and administered, largely influence taxable capacity by restricting the kind of taxes and the amount of revenues which government can raise through taxation. In analyzing the problems of taxable capacity, the nature of a country*s tax structure may be of more import ance than the aggregate level of taxes. Unfortunately, the concentration of attention on the effects of aggregate i 13 Anderson, op. cit.. p. 569. ^For an extensive discussion of the constitutional and statutory limitations of taxation in the United States, see Anderson, op. cit., pp. 20-49. 36 tax load has diverted from the more important problems of analyzing how a tax structure can be developed to produce necessary revenues with minimum adverse consequences. In developing a tax system, a number of factors must be taken into consideration. First, taxes must be "fair,” "equitable," or "just.” Although these concepts are some what subjective in nature, every effort must be made to bring taxes close to the society conception of ’ ’fairness,” ’ ’justice,” and ’ ’equity.” Secondly, taxes must yield adequate revenues to finance government expenditures. The ’ ’adequacy of yield” principle dictates that taxation should not be so heavy as to impair the revenue productivity of tax base. A highly graduated tax system may seriously affect the ’ ’ basic economic incentives” and productivity and thereby may decrease the tax base. A tax system which places heavy burdens on the gains from risky investment, ior it taxes income at a highly graduated rate, or it does not allow for "reasonable” exemption and business losses, may prove detrimental to the operation of the economy. Thirdly, taxation must be flexible in yield in a sense of being able to produce more revenue in times of need. Every effort must be made to devise a tax system which can easily i be expanded by changing the methods of taxation, rates, and bases in times of need. Fourthly, taxation must be adaptable or adjustable to changes in economic and other conditions. This principle of taxation, however, is often difficult to achieve because of many constitutional and statutory limitations. Finally, the tax load must be so distributed as to be considered ’ ’fair” and "just” by tax payers. A tax distribution which is considered "unjust" and "unfair" by taxpayers is bound to create unfavorable IS attitude toward taxation. It seems clear, therefore, that there exists a strong relation between tax structure (the "types and arrangement of taxes") and taxable capacity. A sound tax structure can absorb a relatively large portion of national income without being unduly repressive or inflationary. On the other hand, a poor tax system often brings the tax limits into operation much sooner than the economic condi tions of the country would tend to indicate. Moreover, taxable capacity largely depends on the diversity of taxes which can be effectively utilized. Lewis H. Kimmel, for example, points out that "other things being equal, the larger the number of revenue sources that are both productive and acceptable, the greater is taxable capacity. The three reasons which have been advanced Dan T. Smith, "Analysis of Factors Limiting Taxable Capacity," The Limit of Taxable Capacity (Prince ton: Tax Institute, Inc., 1953), pp. 3-6. ■^Kirnmel, Taxes and Economic Incentives, p. 12. 38 to support this view are: (1) the greater the reliance on few taxes, the stronger the tendency for the law of "diminishing returns" to limit the revenue productivity of the existing taxes, (2) the imperfect nature of most taxes coupled with imperfect administration suggest the extreme difficulty of depending on one or few taxes for the entire or most of the needed revenues, and (3) the heavier the reliance on a few taxes, the greater the problems of 17 administration and enforcement. Finally, there is a strong relation between taxable capacity and tax administration. An effective and intel ligent tax administration, i . . . can bring to light ways and means of improving the law; it can contribute to a wholesome taxpayer morale; it can lighten both the psychological and economic burdens of taxation; and it is an important element in over-all fiscal policy. Moreover, good tax administration can make for greater tax equity and fairness. . . . Finally . . . it will aid in collecting the neces sary revenue for governments with a minimum of. friction and with an optimum of distributional justice.18 In view of all the merits which one can single out for a good and effective tax administration, then it be comes clear that tax administration is one of the major ■^Ibid., pp. 12-13. ^Anderson, op. cit., p. 110. 39 determinants of taxable capacity. After all, ’ ’the purpose of taxation is not its administration; but without the administration, none of the purposes of taxation can be achieved.”^ Thus, the nature of tax structure, the kinds and diversity of taxes, and the quality of tax administration are the very essence of taxation and taxable capacity. As we shall see in later chapters, a poor tax structure plus a dishonest and ineffective tax administration form one of the most troublesome spots in the tax systems of the under-developed countries. Present State of the Economic System Taxable capacity is also correlated with the pre vailing phase of the economic cycle (prosperity, recession, depression, or inflationary boom). In analyzing taxable capacity, one must not overlook the fact that the ’ ’present state” of the economy not only reflects itself in the economic productivity and the level of national income, but also affects the public attitude toward government outlays and taxes. If the economy is in the stage of prosperity and enjoys a high level of production and income, then Luther Gulick, "Basic Goals of Tax Administra tion," Income Tax Administration (New York: Tax Institute, :Ine., 1949), P* 13. Cited and quoted by Anderson, op. cit., p. 95. peoplefs economic ability to bear taxes is enhanced and the economy can afford additional public services. Fur thermore, in time of prosperity, the economy needs of such public services as education, highways, and others are increased. On the other hand, in times of recession or depression people may expect more public spending to bring about prosperity, yet additional taxation may not only be economically unfeasible and undesirable, but also public attitude toward taxation may be very hostile. Furthermore, distinction must be made between the taxable capacity of a country in time of war or peace. |The limits of taxable capacity in peacetime might be easily surpassed in time of war without any serious repercussions. In time of war, government must incur a great deal of military expenditure not by choice but by necessity. It is furthermore argued that a large part of war expenditures should be financed by taxation not only for economic reasons (such as controlling inflationary tendency and profiteering, curtailing private consumption, and so ■forth), but also for noneconomic reasons such as a more equitable distribution of war burden, a high psychological {acceptance of heavy taxation, and so forth. Thus, a country enjoys a higher taxable capacity in time of war, other things being equal, not only because the country enjoys a higher economic ability to bear taxes, but also 41 because the patriotic attitude of the people produces a greater willingness to sacrifice and bear taxes. Type of Economic System Taxable capacity is also influenced by the type of economic system to which taxes are applied. It is asserted, for example, that a totalitarian economic system has a greater taxable capacity than a capitalistic, free enterprise system. A non-totalitarian economic system is greatly concerned with the fact that taxation should not seriously impair the private economic incentives and arouse hostile psychological and political attitudes toward government and taxes. In a totalitarian society on the other hand— where the state is the most important economic unit and where the political organization does not allow significant individual reaction toward government activity-- the private economic incentive and the psycho-political attitudes of people are (or have been made) tax inelastic. In short, in a free-enterprise, where "the individuals are carrying the ball,” government must apply its fiscal power with great caution, whereas in a totalitarian economy, where the state is the chief operator, taxation virtually becomes a process of taking from one hand and giving to another hand. Thus, the economic, psychological, and political limitations of taxation in a socialistic or a totalitarian economy are practically set by the state. 42 Attitudes of the People The reactions of the people toward government and taxes are of significant value to the determination of taxable capacity, ”... insofar as taxation influences their sense of ’fairness,* their incentives to work, to produce, and to invest, and their willingness to forego satisfactions. It is probably true that the economic limits of taxation are the most important ones, and the public atti tudes toward taxes are greatly influenced by economic conditions* Nevertheless, it is also very important that taxpayers regard their taxes as ”just” and ’ ’reasonable.” In a free, democratic society where the taxpayer is the ’ ’final arbiter,” if these conditions are not met, . . ability to raise revenues may be held to a point well below 21 that indicated by available resources.” What constitutes the concept of ’ ’ just” and ’ ’reason able” taxes remains controversial. One fact appears to be unchallenged, however: Public attitudes toward taxes are the product of economic, psychological, and political factors. And, in a democratic society, one should not overlook the significance of all these factors in the i determination of taxable capacity. 20 Anderson, op. cit.. p. 569. 21 Kinniel, Taxes and Economic Incentives, p. 14; 43 The preceding pages presented a broad and general discussion of taxable capacity and some of its major determining factors. Such a broad and general approach, however, is nothing new and its contents have been known to the students of public finance and taxation for a number of years. Our discussion, however, indicated that the relative character of taxable capacity and its determining factors suggest that the problems of taxable capacity could be best dealt with, if studied tinder specific sets of circum stances. That is why the following chapters treat the problems of taxable capacity in highly-developed economies. It is hoped that such a selective approach will shed some light on the practical aspects of taxable capacity. CHAPTER III THE FRAMEWORK OF TAXABLE CAPACITY: GOVERNMENT EXPENDITURES AND TAXATION The preceding chapter reviewed the fundamental determining factors of taxable capacity. The present chap- ter and the one to follow are mainly concerned with an analytical discussion of taxable capacity of Madvanced” economies. Scanty information on tax burdens of many highly-developed countries, however, has forced, and the similarity of the prevailing conditions in most of these countries has induced us to limit our analysis to that of the United States. Therefore, in this chapter an attempt will be made to examine the role and the development of public finance in the United States with particular emphasis on the eco nomic effects of government financial transactions on the “basic economic incentives,” the level of national income, the distribution of income, the allocation of resources and economic growth. An analytical examination of the taxable *Tor an account of tax burdens of some countries see, J. Moss, “Tax Burdens in Common Market Countries,” National Tax Journal. XI (September, 1959), 216-31. 44 45 capacity in the United States will be made in the following chapter. X. THE ROLE AND DEVELOPMENT OF PUBLIC FINANCE IN THE UNITED STATES2 The growth of the expenditures and revenues of all units of the United States governments in the last few decades has been phenomenal. Today, our governments take from us annually astronomical sums in form of taxes and borrowing and return to us an amazingly large range of goods, services, and cash transfer payments. 2Public finance, of course, encompasses more than just public expenditures and taxation. It must definitely include an examination of public borrowing. So long as government borrowing serves either as a supplementary source of government financing or even as an alternative method for taxation, then public borrowing comes to have a direct bearing on taxable capacity. The economic effects of a program of government expenditures financed by borrowing are somewhat different from the effects of a similar program financed by taxation. Yet an increasing public debt exerts a great deal of influence on the "basic economic incentives," allocation of resources, the size and the distribution of national income and economic growth. In addition, a large public debt may create management problems and it may intervene with monetary and credit policy. In spite of these considerations, 'however, no attempt will be made to deal with public iborrowing for two reasons. First, while continual borrow ing and a permanent increasing debt are fiscal possibili ties, yet it is felt that a greater part of government expenditures should in the long-run be financed out of taxes and other current revenues. Secondly, so long as we are concerned with taxable capacity, the lack of an analysis of public debt does not change the essence of the arguments. 46 The importance of the public sector in the total economy cannot be measured accurately— not only because of the difficulty of measuring the monetary values of certain public services (e.g., Sherman Anti-Trust Act of 1890, or the Employment Act of 1946), but also because a great num ber of government goods and services are not sold at market prices. Certain comparisons, however, can be made to show roughly the relative importance of the public sector in the over-all American economy. While we are concerned with the taxable capacity of the American economy, yet no analysis of tax limits can be effectively made with disregard to public expenditures and revenue. Thus before we embark upon the problems of taxable capacity, a brief account of the scope and nature of public expenditures and revenues will be given. The Scope and Nature of Public Expenditures The important role which both the quantity and quality of public outlays play in the total economy, eco nomic incentives and taxable capacity is beyond any ques tion. In order to provide a clearer understanding of the , relation of public spending and taxable capacity an attempt iis made to examine two aspects of government expenditures: (1) the growth of public expenditures, and (2) the distri bution of public outlays among different uses. 1. The growth of public expenditures. Government spending has been growing not only absolutely but also relative to population and national income. The upward trend of public spending . . is relevant and significant because it measures the total tax burden which the economy as a whole must ultimately bear.” Table I provides a few comparisons which help to gain perspective in the trend and pattern of public spending. As Table I shows, the upward trend since 1929 in government spending has been extremely rapid and substan tial. With periodic spurts during wars and business cycles, the spending growth shows a "long-run” upward trend. Some observers may argue that a period of thirty years does not constitute a long-run trend. This is a matter of definition and without getting into what may constitute a long-run trend, we may conclude that govern ment has become a major participant in the American 4 economy. William H. Anderson, Taxation and the American Economy (New York: Prentice**Hall, Inc., 1951), p. 5. ^In order to measure and evaluate the relative role 'of government in the economic life of a nation, one must compare the "value produced" by public sector with that produced by private sector. An expenditure-to-national income ratio means little as a measure of public functions, for monetary figures for government expenditure do not measure its value. Lack of an adequate measure leaves no other alternative but to compare government expenditure TABLE I AMERICAN GOVERNMENT EXPENDITURES AND NATIONAL INCOME SELECTED CALENDAR YEARS, 1929-1957 (Millions) Year ------ Government Expenditures** Federal0 State and Local Total National Income Per cent of National Income 1929 $ 2,645 $ 7,582 $10,227 $87,814 12 1933 3,986 6,690 10,676 40,159 27 1939 8,955 8,567 17,522 72,753 24 1946 37,014 9,990 47,004 180,879 26 1950 41,027 20,089 61,116 241,876 25 1954 69,570 27,171 96,741 301,794 32 1955 68,915 29,663 98,578 330,206 30 1956 71,900 32,242 104,142 349,356 30 1957 79,582 34,922 114,504 363,951 31 Expenditures on income and product account. They are on an accrual basis, including trust account transactions with the public and excluding capital transactions that do not represent current production. ^Federal data include expenditures for grants-in-aid to state and local govern ments. These amounts have been excluded from state and local total expenditures to avoid duplication. 4 SOURCE: Tax Foundation, Facts and Figures on Government Finance. 1958-59 (New York: Tax Foundation, Inc., 1958), pp. 26, 31; and National Industrial Conference Board, The Economic Almanac (New York: National Industrial Conference Board, various years). 49 While state and local spending has been increasing, the most relevant and significant trend has been the "topsy-like” growth of federal expenditures. Table I shows that the share of the federal government of the total public outlays has increased from approximately 25 per cent to 75 per cent of the total. 2. The distribution of public expenditures. The uses which are being made of public outlays are relevant to taxable capacity. A break-down of public spending accord ing to its nature and purpose is quite essential to our understanding of taxable capacity. In the first place, such a break-down may shed some light on the nature of various public expenditures and it may give some indication as to whether certain government outlays are ’ ’desirable," "necessary," or "productive." The relation between taxable capacity and the nature of public expenditures has already received adequate consideration. Suffice to say that the nature of public outlays not only affect the economic capacity of people to bear taxes, but also influences iwith national Income on the basis that so long as govern ment expenditure represents a withdrawal of funds, ma terials and services (except "transfer" expenditure) from private use, such comparison will more or less represent the division of public and private sectors. See William J. Shultz and C. Lowell Harriss, American Public Finance (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1954), pp. 71-72. their psychological attitude toward public activities and taxation. In the second place, a break-down of government spending according to its nature is essential to an under standing of economic effects of government expenditures on the size and distribution of national income, volume of employment, level of prices, and particularly on the allocation of resources and economic growth. This aspect of public expenditures will be discussed later. Suffice to conclude that: The effects of particular government expenditures on the economy are influenced by the nature of the expenditures, whether they are factor-purchase or ’ ’exhaustive"— those made for the purchase of goods and services— or transfer expenditures--those involving merely a transfer of purchasing power without the recipients providing goods or services to the govern ment in exchange.6 Finally, an examination of the relative amounts of expenditures made for various purposes has great practical .importance for the possibility of reduction of public spending. For a detailed functional classification of public outlays and their contribution to the functioning of economy, see Harold M. Groves, Financing Government (third ed.; New York: Henry Holt and Company, 1950), pp. 463-65. °John F. Due, "Government Expenditures and Their Significance.for the Economy," Fiscal Policies and the American Economy, ed., Kenyon E. Poole (New York: Prentice Hall, Inc., 1951), p. 202. In order to show the pattern and distribution of public expenditures, the total outlays of all units of government must be considered. However, different sta tistical procedures and the existence of grants-in-aid make accurate and definite grouping of data rather difficult. Nevertheless broad groupings are shown in Table II. Table II presents a rough functional classification of government expenditures for the year of 1957. Our survey of the purposes of public spending, however, will be incomplete without saying a few words on the historical trend of public spending. In the area of federal spending a number of major tendencies can be observed: (1) while the federal government spent about 190 million dollars for national defense in 1900, financing of national security in i 1957 cost a little over 44 billion dollars; (2) while the share of veterans1 services and benefits of the total federal expenditures was negligible at the turn of the century, the central government spent about 5 billion dol lars for veterans* aid in 1957; (3) the payment of interest on federal debt has been a growing figure— a figure which stood at 40 million dollars in 1900 and 7,308 million dollars in 1957; and (4) finally an upward trend in all other federal outlays.^ ^Tax Foundation, Facts and Figures on Government Finance, 1958-1959 (tenth ed.; New York: Tax Foundation, Inc., 1958), p. 80. It should be noticed, however, that the figures presented above tend to show the absolute 52 TABLE II FUNCTIONAL DISTRIBUTION OF AMERICAN GOVERNMENT BUDGET EXPENDITURES, FISCAL YEAR 1957a (Millions) Purpose of Expenditures Amount Major National Security $ 44,414 International Affairs and Finance 832 Veterans* Service and Benefits 4, 793 Labor and Public Welfare 6,377 Agriculture and Agricultural Resources 4,582 Interest on Public Debt 8,673 Education 14,501 Highways and Streets 7,762 Health and Hospitals 3,137 Protection (Police and Fire) 2,271 General Government and Others 19.723 Total Expenditures $117,065 aWhile in Table I grants-in-aid were counted as expenditures of the first disbursing unit, the grants-in- aid in this table are shown as the expenditures of the last disbursing unit. SOURCE: Tax Foundation, Facts and Figures on Govern ment Finance. 1958-59 (New York: Tax Foundation, Inc., 1958), pp. 79, 81, 138, 152, and 209. I The scope of state and local activity has broadened steadily and startlingly in the first half of the twentieth century. Certain expenditures, however, have shown a relatively higher rate of growth: (1) expenditure on public education has been a rising figure. While the state and local governments spent $255 millions on public education in 1902, the 1957 outlay for education stood close to $15 billions; (2) state and local expenditures for highways and streets has been a rising figure also— a figure which increased from $175 millions in 1902 to approximately $8 billions in 1957; and (3) a substantial increase in all other state and local outlays. Federal expenditures comprise such a large per centage of total public outlays and the peculiar nature of certain federal expenditures call for a separate analysis of federal spending. Table III presents a brief account of federal outlays and its functional classification. A number of conclusions--which are extremely rele vant and significant to the economic effects of federal growth of certain federal government expenditures. If we examine the relative growth of various federal outlays, ithen the growth of some expenditures is not as phenomenal as it seems to appear at first. For example, while the !federal expenditure for national defense comprised 60 per cent of total federal expenditure in 1957, 40 per cent of total federal outlays went for national defense in 1900; the payment of interest on federal debt serves as a better iexample. The payment of interest on federal debt was 10 per cent of the total federal expenditures for both of the years of 1900 and 1957. 54 TABLE III THE FUNCTIONAL DISTRIBUTION OF FEDERAL EXPENDITURES, 1957 (Millions) Purpose of Expenditure Amount Major National Security $ 44,414 International Affairs and Finance 832 Veterans* Aid 4,793 Interest on Federal Debt3 7,308 Commerce and Housing 1,453 Natural Resources 1,296 Labor and Welfare 2,966 Agriculture and Agricultural Resources^ 4,582 General Government 1,789 aIt includes interest on war debt and on debt incurred from deficit financing. ^It includes $3.5 billions of federal aid for price stabilization. SOURCE: United States Treasury Department, Treasury Bulletin (Washington, D.C.: United States Government Printing Office, 1958), pp. 6-7. 55 » i ( expenditures and the possibility of their reduction— can be drawn from Table III. In the first place, the pattern of federal spending is characterized by a surprising concen tration of the total expenditures in a few major items, notably national defense and related expenditures. Secondly, the obligatory nature of some of the federal outlays (veterans* aid and interest payment) somewhat rigidifies the federal spending policy and restricts the possibility of their reduction. Thirdly, a greater part of federal expenditures is of "factor-purchase" or "exhaus tive" kind--a point which is highly relevant to the analysis of the economic effects of government spending. Finally, since some of the federal outlays have arisen and are maintained for social and political reasons, one must go beyond economics to explain the nature of some of the federal outlays and the possibility of their reduction. The Scone and Nature of Taxation While an attempt was made to analyze certain aspects of public spending, we still have before us a greater hurdle to surmount--the nature and the problems of tax ation. American taxation has undergone great changes that Q need brief examination.0 It has emerged from a stage Q °For a well-balanced account of the development of taxation in the United States, see C. Lowell Harriss, "Public Finance," A Survey of Contemporary Economics, ed., Bernard F. Haley (Homewood, Illinois: Richard D. Irwin, Inc., 1952), II, 261-306. of infancy to a giant only in the last fifty years. It absorbs such a substantial portion of our national income that its aftermaths on our basic economic decisions have become the first order of the business. As one fiscal economist has well stated, ”... the business man who never used to make an important decision without consulting his banker now does nothing without first seeking the advice of his tax attorney.A tax system of this magni tude which takes about 30 per cent of national income, is bound to have decisive effects on the national economy. Furthermore, two world wars and a major depression have taught the important lesson that taxes can do more than to raise revenue. We have come to use taxation for the pur pose of controlling the national economy and achieving prosperity. As one economist points out, . . . tax system of our past has been too often a series of extemporized responses to the immediate purpose of war and depression. Rarely, until recently, have we tried to use taxes to shape events. We have let events shape tax policy. The statutory provisions of the American tax system--particularly those of the federal government— 1 Q ^Gordon E. Keith, "Repercussions of the Tax System on Business," Fiscal Policy and the American Economy. ed., Kenyon E. Poole (New York: Prentice-Hall, Inc., 1951), pp. 315-16. ■ ^ R a n d o l p h e. Paul, Taxation in the United States (Boston: Little, Brown and Company, 1954), p. 686. have increased ". . . to the point at which an understand ing of the Internal Revenue Code [threatens] to defy the intellectual capacity of American taxpayers and their advisers." In short, American taxation, particularly Federal taxation, has become so complex in itself and its relations to the private sector of the economy that fiscal economists i have made an extensive use of Smithian "division of labor.'* A number of changes which have taken place in the American tax system merit brief explanation: (1) the volume of tax collection has increased substantially; (2) new taxes have become a part of the tax structure; (3) the relative ; contribution of various taxes to the public purse has undergone some changes; (4) the tax system, particularly that of the federal government, has become more progressive in the last fifty years or it has become more related to the concept of the ability-to-pay; and (5) finally taxation has become a more effective tool for economic stability. Before we delve into the nature and problems of taxable capacity, an attempt will be made to examine: (1) the growth of tax revenue collection; and (2) the relative importance and contribution of different taxes. 1. The growth of tax revenue collections. The volume of tax collection in the last few decades by all n ibid.. p. 571 58 levels of government is startling enough. The reasons for this tremendous increase both in the pace and scale are not far to seek and one may find them to be those factors which have boosted public expenditures to a staggering figure. Table IV shows the scale and pace at which tax collection-- particularly that of federal government— has been increas ing. While this upward trend in tax collection is funda mental to our analysis, yet one should not lose sight of the fact that the ’ ’tax burden” of a tax collection is determined partly by the actual amount of tax collection and partly by changes in the level of national income, population, and the level of prices. To illustrate this important point, it can be shown that while tax collection in actual dollars increased nearly tenfold between 1933 and 1954, the increase was less than fivefold in constant pur chasing power. Or when population change over this period is considered, the increase in the tax burden approximates fourfold. Finally, if one relates tax collections to national income, the tax burden remained approximately the same between 1933-1954.^ 2. The nature and the relative contributions of different taxes. It has already been pointed out that taxable capacity is greatly influenced by the nature of “ ^Shultz and Harriss, op. cit.. pp. 251-53. TABLE IV TAX RECEIPTS AND NATIONAL INCOME CALENDAR YEARS 1929-1957 (Millions) Year Federal Tax Receipts3 State and Local Total National Income Per cent of National Income 1929 $ 3,724 $ 6,552 $10,276 $87,814 12 1933 2,618 5,922 8,540 40,159 21 1939 6,662 7,899 14,561 72,753 20 1946 38,902 10,995 49,897 180,879 28 1950 49,856 17,423 67,279 241,876 28 1954 63,180 23,825 87,005 301,794 29 1955 72,099 26,105 98,204 330,206 30 1956 78,062 28,853 106,915 349,356 31 1957 81,706 30,631 112,337 363,951 31 aBusiness taxes are on an accrual basis. Tax receipts are not o£ refunds and include contributions for social insurance. SOURCE: Tax Foundation, Facts and Figures on Government Finance. 1958-59 (New York: Tax Foundation, Inc., 1958), pp. 27, 31. U i VO 60 the tax structure, the kinds and diversity of taxes, and the effectiveness of the tax administration. These aspects of taxation not only have a direct bearing on the ability of an economy to withstand a tax burden, but also on the economic effects of taxation— a subject which will be i discussed later. It seems of utmost importance, therefore, to present a brief discussion of the nature and the kinds of the American taxation and the changes which have taken place over the last few decades. Prior to World War I, the primary sources of federal tax revenue were customs duties and liquor and tobacco excise taxes, which accounted for over 90 per cent of total revenue. Since the beginning of the present century, new taxes have been levied and the rates of new taxes have been increased with individual income tax and corporation income tax being the most dominant. As Table V shows, the primary sources of revenue for federal government have been the personal and corporation income taxes accounting for 73 per cent of total revenue in 1958. Excise taxes are next in importance, contributing 11 per cent of total revenue, followed by employment taxes and estate and gift taxes, contributing 10 per cent and 1 per cent of the total revenue respectively. The primary source of revenue for state governments, as shown by Table VI, is the retail sales tax, accounting TABLE V FEDERAL TAX COLLECTIONS BY SOURCE, SELECTED FISCAL YEARS 1929-1958 (Millions) Source 1929 1933 1939 1946 1950 1954 1956 1957 1958 Individual Income Taxes $1,096 $353 $1,029 $18,705 $17,153 $32,814 $35,338 $39,030 $38,569 Corporation Income and Profit Taxesa 1,242 394 1,283 12,906 10,855 21,546 21,299 21,531 20,533 Excise Taxes 540 839 1,768 6,684 7,598 9,532 10,004 10,638 10,814 Estate and Gift Taxes 62 34 361 677 706 935 1,171 1,378 1,410 Employment Taxes - - 740 1,701 2,645 5,108 7,296 7,581 8,644 Customs 602 251 319 435 423 562 705 754 800 Railroad Unemployment - <w» 129 19 28 34 78 100 Miscellaneous tm Mi «■» mm - - 5 15 8 aFor years prior to 1954, except 1933, includes capital stock tax and, in 1939, the unjust enrichment tax. SOURCE: Tax Foundation, Facts and Figures on Government Finance. 1958-59 (New York: Tax Foundation, Inc., 1958), p. 107. TABLE VI STATE TAX COLLECTIONS BY SOURCE, SELECTED FISCAL YEARS 1932-1958 (Millions) Source 1932 1936 1940 1944 1948 1952 1957 1958 General Sales and Use Taxes $ 7 $364 $499 $720 $1,478 $2,229 $3,036 $3,497 Motor Vehicle Fuel Tax 527 687 839 684 1,259 1,870 2,687 2,914 Tobacco Production Sales Tax 19 44 97 159 337 449 515 616 Alcoholic Beverage Sales Taxes and License 1 166 255 324 499 519 626 647 Motor Vehicle and Operators1 Licenses 335 360 387 394 593 924 1,295 1,411 Income Taxesa 153 266 361 762 1,084 1,751 2,263 2,561 Property Taxes 328 228 260 243 276 370 467 533 Death and Gi£t Taxes 148 117 113 110 179 211 310 351 Unemployment Compensation Taxes - 23 844 1,319 1,059 1,433 1,315 1,488 Others 372 388 502 676 1,036 1,533 2,176 2,375 aIn several states individual and corporation income taxes are not segregable. SOURCE: Tax Foundation, Facts and Figures on Government Finance, 1958-59 (New York: Tax Foundation, Inc., 1958), p. 164. N) 63 for 22 per cent of the total receipts for 1958. The other sources of revenue in order of their importance are indi vidual and corporation income taxes (16 per cent), gasoline tax (12 per cent), motor vehicle license taxes (9 per cent), and cigarette and liquor taxes each accounting for 4 per cent of total receipts. As Table VTI shows, local governments rely heavily on property taxation which accounted for 59 per cent of total receipts for 1957. In fact, if tax receipts are considered only (excluding revenues from utility and liquor stores and other charges), property taxes contributed 87 per cent of total receipts in 1957. Although other taxes are being used by the local governments, their contributions are relatively minor. These tables point to one important change which has taken place in the American tax structure: Although for a long period the low income groups bore the brunt of tax ation (which basically consisted of customs duties and excise taxes), the recent trend has been toward more income taxation, particularly at the federal level. In 1939, for example, income and profit taxes accounted for about 42 per cent of the total receipts, whereas they accounted for 57 per cent of the total in 1957. This trend has been more pronounced at the federal level. While the federal receipts of income and profit taxes were 41 per cent of the total receipts in 1939, the share of these taxes increased TABLE VII LOCAL TAX COLLECTIONS BY SOURCE, SELECTED FISCAL YEARS 1932-1957 (Millions) Source 1932 1936 1940 1946 1952 1956 1957 Property Tax $4,159 $3,865 $4,170 $4,737 $8,282 $11,282 $12,618 Sales and Gross Receipts 26 90 130 183 627 889 1,025 Income Taxes - 19 38 93 164 205 License and Others 89 128 178 199 465 657 664 Charges and Others 605 450 510 925 2,205 3,246 3,507 Utility and Liquor Stores® 463 564 717 1,235 2,184 2,835 3,016 Insurance Trust® 39 50 68 99 262 380 433 Total of Taxes*5 4,274 4,083 4,497 5,157 9,466 12,992 14,511 ®Not taxes. ^Excludes unemployment tax collections. It also excludes other sources of revenue such as utility and liquor stores, insurance trust and inter-governmental revenues. SOURCE: Tax Foundation, Facts and Figures on Government Finance, 1958-59 (New York: Tax Foundation, Inc., 1958), pp. 214-15. Os - ! > 65 to 75 per cent of the total in 1957. As for the over-all structure of present taxation in the United States, the individual and corporation income taxes are the most important elements accounting for 56 per cent of the total tax receipts. Sales and excise taxes comprise the next important group contributing 17 per cent of the total. Property taxes, accounting for 10 per cent of the total, and other taxes follow. II. THE NET ECONOMIC EFFECTS OF TAXES AND EXPENDITURES In the preceding pages we have reviewed the struc ture of public expenditures and taxation. The most import ant and relevant aspects of public finance— the economic effects of public spending and taxation— however, were not discussed for the simple reason that a full inquiry into the economic effects of public activities on the function ing of the economy calls for an integrated account of both public spending and taxation.^ The economic effects of ^Many of the eighteenth and nineteenth century writers tended to emphasize more or less one aspect of public finance. A case in point is the attitude of Mercantilist economists as opposed to the English writers of laissez-faire school. The Mercantilist writers argue that ". . . government expenditures were an unmixed bless- ing, contributing to industrial and commercial prosperity, injuring none, and benefiting all." The classical econo mists, on the other hand, "... tended to ignore the results of government expenditures and studied the reduc tion of purchasing power by taxation (and its retarding effects on economic incentives and economic growth)." Shultz and Harriss, o p . cit.. p. 78. 66 expenditure-tax program involve exceedingly large series of intricate ramifications that we cannot examine them in detail. As one economist has well stated, Not enough is known . . . of the short- and long- run elasticities of desire for income and leisure, for savings and consumption, nor of the importance of non-monetary incentives to business activity. Even the more firmly-held principles concerning the effects of taxation and expenditure upon savings, consumption, and incentives to invest have not been adequately veri fied. In spite of these difficulties, an attempt will be made to examine the net economic effects of expenditure- tax system on the allocation of resources, the level of national income, the distribution of national income and economic growth. The Net Effects on the Allocation of Resources The effects of expenditure-tax policy on the alloca tion of resources depend on many factors (such as the level of employment, the nature of public expenditure, types of taxes, the strength and the sensitivity of the basic eco nomic incentives, and others) which make any exact formula tion difficult. Our analysis must necessarily embrace a trail of qualifications. Notwithstanding, the problem merits brief comment. ^Anderson, o p . cit.. p. 505. 67 First, let us examine the effects of public expendi tures on the allocation of resources.^ It is of utmost importance to point out at the outset that the effects of public outlays on allocation of resources basically depend . on the nature of expenditures and the level of employment. Under conditions of "full employment,” a public expenditure of ”factor-purchase” (those involving purchase or hire of factors of production) may reduce the output of the private sector since these projects compete with private expendi tures for factor units. In addition to shifting resources directly, public outlays through their ”announcement effects”— the public finance equivalent of substitution effects--may give rise to secondary reactions which may also change the allocation of resources. Expenditures on highways, for example, may induce the production of auto mobile and dampen railroad construction. Other public expenditures, on the other hand, may reduce the production of those goods and services which serve as substitutes for public services and may stimulate the production of those goods and services which are complementary to public services. While under conditions of "full employment,” ;public expenditures involve a shift of resources, from ■^For a very valuable discussion of the effects of public expenditures on allocation of resources, see Due, "Government Expenditures and Their Significance for the Economy,” pp. 201-51. the private to the public sector, the effects of public activities on the composition of national product depend on types of goods and the respective production policy of private enterprise and the government. The allocative effects of the public production of "individual goods"— those which otherwise would be produced in more or less comparable volume by private enterprise, like electric power— depend on the government production policy. If government policies with respect to price, output, quality of service, and investment are more or less the same as with private operation, then the allocation of resources will not be affected substantially. It must be pointed out, however, that the policies may not be necessarily identical. For example, some public electric-power systems have adopted a low-rate policy to stimulate the use of their product. In some other cases, public production of electric power has perhaps resulted in higher rates due to inefficient operation and political interference. Invest ment policy may also differ in so far as public enterprises may be more willing to undertake long-range investments to meet future needs. In spite of all these considerations, however, most public enterprises in the United States producing "individual" goods follow more or less the same policy as private companies. It seems, therefore, that the public production of these goods has no significant 69 1 6 effects on the composition of the national product. The pronounced effects of government expenditures on the composition of national product is in the area of "social goods”— those goods which due to their nature can not be produced by private enterprise like defense. Under conditions of "full employment,” an increase in the output of these "social goods" reduces the production of the privately-produced goods and thus changes the composition 1 7 of national product. Transfer expenditures (those involving merely a transfer of purchasing power without the purchase or hire of factor units), other than subsidies which are intended to alter the output of firms, do not affect the allocation of resources, except for resources which are necessary for the administration of the program. Secondary effects, however, are inevitable if the recipients of government expenditures and the financiers of public outlays have different propensities to consume and consumption patterns. These transfer expenditures may also alter the consumption- saving ratio and thus the rate of capital formation and the composition of national product. Under conditions of less than "full employment," 16Ibid., pp. 230-32 • ^Ibid., pp. 235-39 70 however, the effects of public expenditures on the alloca tion of resources are greatly modified since public com petition with private sector for factors hardly manifests itself. In fact, to the extent that government expendi tures lead to an increase in private consumption (and possibly private investment), the ’ 'marginal social bene fit" of public outlay includes not only the benefits received from public services, but also the gains to the economy from the secondary increase in national income and employment. Taxation can also exert some influence on the allocation of resources through its "purchasing-power" and "announcement effects." The extent and degree of these effects, of course, depend on the types of taxes used, public reaction to taxes, the strength and elasticity of the "basic economic incentives," and a host of other factors. Nevertheless, an attempt will be made to examine the effects of taxation on the allocation of resources very briefly. In the first place, certain taxes through their "announcement effects" can result in direct shifting of purchases and output. Excise taxes, for example, may dis courage the consumption of the taxed goods. Whether the 18 Even under the condition of less than "full em ployment," public projects may divert certain types of factors from the private sector and affect their costs. 71 output of these goods changes, however, depends on the elasticity of their demand and the use of public expenditures. In the second place, taxes through their "purchasing-power effects" may cause a change in the distribution of income and thus a shift from "rich" goods to "poor" goods causing a change in the pattern of con sumption. In the third place, taxation may alter the consumption-savings ratio and thus the relative output of consumption goods and producer goods. Finally, taxation (in conjunction with certain public expenditures) can affect the relative supply of factors of production and their prices. It is argued, for example, that highly progressive taxation, by affecting the incentive to work may restrict the supply of labor and labor mobility. Furthermore, highly progressive taxation, by affecting incentives to save and to invest and take risks may affect the supply of capital and the amount of investment. Certain public expenditures, on the other hand, may also affect the quantity and quality of factor units. Expendi tures on education, while they may reduce the supply of labor in the short-run, may increase the supply of trained labor over the long-run. Or, conservation programs, while they may reduce the current supply of natural resources, may increase it in the long-run. The extent and direction of the effects of taxation and spending on the "basic 72 economic incentives” and thus the relative supplies of factor units are still largely conjectural.^ Yet these changes in the supplies of factor units tend to change the prices of the factors and consequently the relative output of various goods since different proportions of factors are required for different goods. Thus taxation, by altering the relative supplies of factors, the consumption pattern, and the consumption-saving ratio, can affect the composi tion of the national product. The Net Effects on the Level of National Income^ The expenditure-tax system can affect the level of both money and real national income by influencing either ”. . . the quantity and quality of resources . . . availa ble for use in production,” or by altering ". . . the extent of utilization of available resources or . . . ^An attempt will be made to examine the effects of taxation on the ’ 'basic economic incentives” in the latter part of this thesis. The literature dealing with the effects of public finance on national income is voluminous. Two articles dealing with the problem, however, merit mentioning. B. Higgins, ”A Note on Taxation and Inflation,” Canadian Journal of Economics and Political Science. XIX (August, 1953), 392-402. H. M. Somers, "Impact of Fiscal Policy on National Income,” Canadian Journal of Economics and Political Science, VIII (August, 1942), 364-85. For a mathematical presentation of the effects of public finance on total spending and national income, see Hackell P. Wald, "Fiscal Policy, Military Preparedness and Postwar Infla tion,” Readings in Fiscal Policy, ed., Arthur Smithies and K. Keith Butters (Homewood, Illinois: Richard D. Irwin, Inc., 1955), pp. 167-69. 73 91 the volume of unemployment."* The net effects of the expenditure-tax system on the level of national income, therefore, are manifested in two ways. First, it may alter the quantity and quality of resources--a point which has already received ample considerations and will receive further attention in a later section. Secondly, the expenditure-tax system affects the level of national income by affecting the volume of spend ing which is an independent determinant of national income 22 and the volume of employment. An increase in total spending, ceteris paribus, results in a rise in the level of national income primarily in real terms if there are unemployed resources and primarily in monetary terms if 23 resources are fully employed. So long as national income 2 - * - John F. Due, Government Finance (Homewood, Illinois: Richard D. Irwin, Inc., 1954), p. 226. 22 **There are, of course, other factors which influ ence the level of national income such as the general level of prices, the relation among specific prices, the loca tional and specific characteristics of expenditures, of workers and other resources, and other factors. So there are limitations as to the effects of spending by government on total spending and thus national income and employment. See Henry M. Oliver, "Fiscal Policy, Employment and the Price Level," Fiscal Policies and the American Economy, ed., Kenyon E. Poole (NewYork: Prentice-Hall, Inc., 1951), Chapter III. 23 *JThe effects of an increase in total spending on the level of money, real national income (or both), and the level of prices depend on the volume of employment and a host of other factors. See John M. Keynes, The General Theory of Employment. Interest, and Money (New York: Harcourt, Brace and Company, 1936), Chapter 21, particu larly pp. 296 and 298-303. 74 is essentially determined by the private expenditures on consumption and investment and government expenditures, the effects of the government expenditure-tax program on the level of national income, volume of employment, and the price level become clear. It must also be emphasized that the effects of the government financial transactions on the level of national income may involve primary as well as secondary influences. In short, the net effects of public activities (the expansionary effects of spending and the contractionary effect of taxation) on the volume of spend ing and thus national income is brought about through their influence on consumption and investment— the two basic determinants of national income. The exact effects of fiscal operations on the volume of consumption and invest ment are still somewhat conjectural and can only be ex pressed conditionally. The effects of public finance on consumption and the consumption-savings ratio depend on the types of taxes used, the purpose of expenditures, the dis tribution of expenditures over different income groups, and ,the reactions of taxpayers and the recipients of public expenditures. The net effects of the expenditure-tax system on investment is very complex. Public spending (and < certain taxes) stimulate private consumption and may en courage private investment. Or, certain public outlays may make certain private investments more profitable. 75 Taxation, however, could affect investment adversely since "... taxes may reduce both the funds for private invest ment and the incentives to invest. . . . Therefore, while the net effects of the government expenditure-tax system on the level of national income (both in monetary and real terms), the volume of employment and the general level of prices depend on their effects on consumption and investment, the effects of fiscal operation on the level of national income become evident since while taxation reduces the flow of purchasing power and thereby reduces the amounts available for consumption and savings, public expenditures contribute to and re-enter the income 25 stream. ^Due, Government Finance, p. 443. ^The net effects of public spending and taxation on the level of national income has been the subject of an intensive examination. Professor Due, for example, argues that "... government expenditures tend to restore the flow of purchasing power . . . to the level which existed before taxes were extracted, if the amount of taxes and expenditures are equal" (Due, Government Finance, p. 432). The extent to which the public expenditures can restore the income stream to pre-tax level depends on the propensity to |spend of the recipients of public outlays and that of the financiers of public expenditures. It is argued, for example, that if public outlays are financed from the "idle !income" of the economy, income stream may become larger even if taxes are equal expenditures. On the other hand, if expenditures are financed out of the "active income" the net effects depend on both the "purchasing power" and "announcement" effects. Some other economists have gone as far as to assert that equal increases of taxes and expendi tures on goods and services ("factor-purchase” type) tend to increase the national income by the value of public 76 The Net Effects on the Distribution of Income There is a growing recognition that government financial transactions tend to change the distribution of income. Although it is recognized that the redistributive effects of fiscal operations can appear in many forms (such as geographical reallocation of income, reallocation of income from one sector of population to another independ ently of income status and so forth), we are mainly con cerned with their redistributive effects on different income groups. The redistributive effects of tax-expenditure pro gram can appear in several ways. In the first place, with goods and services (Arthur Smithies, ’ ’ Federal Budgeting land Fiscal Policies,” A Survey of Contemporary Economics, ed,, Howard S. Ellis [Philadelphia: The Blakiston Co., 1948], I, 187-88). Trygne Haavelmo has also stated that ”... expenditures covered by taxes will raise income (and employment) by the amount of taxes. . . .” His reasoning is as follows: assume that Yn stands for net income (or the sum of incomes at the individuals* disposal after they had paid taxes) and Yg designates gross income (or the sum of individuals* income before taxes). The private demand i(Dp) for goods and services depends on net income or Yn, while the employment depends on gross income or Yg. Thus a public expenditure covered by taxes increase Yg while Yn remains unchanged (Trygne Haavelmo, ’ ’ Multiplier Effects of a Balanced Budget,” Readings in Fiscal Policy, eds., Arthur Smithies and J. Keith Butters [Homewood, Illinois: Richard D. Irwin, Inc., 1955], pp. 335-43). For another 'exposition of the income-generating effects of fiscal operation, see Henry C. Wallich, "Income-generating Effects of a Balanced Budget,” Quarterly Journal of Economics. LIX (November, 1944), 78-91. For a critical review of these expositions, particularly that of Arthur Smithies, see George J. Stigler, ”A Survey of Contemporary Economics: A Review," Journal of Political Economy. LVII (April, 1949), 97-98. 77 a highly-progressive income taxation, wealthier individuals are forced to pay a higher price for government services than those in the lower-income groups. That is to say that the benefit-cost ratios of many public services are smaller for the rich than the poor and consequently those with low income receive more real income from government activities. Education provides an excellent example where those in the lower-income groups not only enjoy the benefits of educa tion itself, but also experience an increase in their earning power. Secondly, certain public outlays (old-age pensions and relief programs) directly augment the money income of the lower-income group. Since these programs are financed by taxes which are largely borne by the higher- income groups, there is a net redistribution of income. Thus, with the present progressive taxation and the bulk of transfer expenditures going to the lower-income groups, the distribution of income is made more equal.^ Several studies have recently been made to determine and measure the net effects of the tax-expenditure system on the distribution of income. John H. Adler has made i i It should be noticed that the primary redistribu tive effects of the tax-expenditure system result from the transfer payments. The redistributive effects of the ”factor-purchase” expenditures are less pronounced, since government employees would draw more or less comparable wages from private industry under a condition of "full employment." 78 a study to measure the ' ‘ composite” effects of the fiscal system (both expenditure and tax programs) on the distribu tion of income for the periods of 1938-39 and 1946-47. According to Adler*s data, the fiscal system has made the distribution of income more equal in 1938-39, in so far as there has been an increase in the income of all income bracket except the highest bracket ($7,500 and over). The net gain has ranged from 41 per cent to about 1.0 per cent of the income, the highest gain, of course, going to those with income of $1,000 or less. It should be noted, however, that this increase in income has not arisen from "soaking the rich” only, but also from government deficit financing. In fact, if the figures are adjusted ; for gains or losses of deficit policy, only the two lowest income groups (under $1,000 - $1,999) and the $5,000 - $7,499 income bracket gained through the redistributive effects of fiscal operations. The remaining four income groups, on the other hand, experienced net losses ranging from 1.0 per cent to 19.2 per cent of income. ^ An examination of the net effects of the public financial transactions on the distribution of income for the period of 1946-47, also showed some equalizing effects. ^John H. Adler, "The Fiscal System, the Distribu tion of Income and Public Welfare," Fiscal Policies and the American Economy, ed., Kenyon E. Poole (New York: Prentice- Hall, Inc., 1951), pp. 395-97. 79 The study for the period under consideration showed an increase of 6.73 per cent in real incomes of those in the under $1,000 - $3,999 brackets (excluding the gains or losses from deficit policy) and a net loss varying from 4 to 23 per cent of the incomes of other income groups ($4,000 - $7,500 and over).28 Professor Musgrave and his associates have also made a study of the distribution of tax burden by income groups for the year 1948, without any reference to benefit re ceived. The study showed that the distribution of the tax burden is regressive for the income groups of $1,500 and less, nearly proportional for those in the $1,500 - $5,000 brackets, and highly progressive for the income groups of $5,000 and over. In short, the study indicated that while the tax structure as a whole is progressive, the tax dis tribution is regressive in the lower-income brackets because although their members are not affected by federal income taxation substantially, yet are subject to large payments of sales, excise and property taxes which are 29 regressively distributed. 28Ibid.. pp. 396-97. ^Richard A. Musgrave, J. J. Carrol, L. D. Cook, and L. Frane, "Distribution of Tax Payments by Income Groups: A Case Study for 1948,” National Tax Journal. IV (March, 1951), 1-53. A number of the assumptions and thus certain conclusions of the Musgrave study have been chal lenged by Tucker. See Rufus S. Tucker, "Distribution of 80 It appears, therefore, that the fiscal system exerts some influence on the distribution of income, yet the exact measurement of these effects is extremely difficult and competent observers often reach different conclusions. The root of the difficulty lies in deficient statistical methods in determining the distribution of income among different income groups, the allocation of the benefits of public services, and the shifting and incidence of differ ent taxes. The Net Effects on Economic Growth We have already had occasion to hint about the effects of fiscal policy on economic development. Our dis cussion of the effects of tax-expenditure policy on the level of real national income has a direct bearing on the issue on hand here. Economic growth itself and the effects of public financial transactions on economic development involve many ramifications which extend beyond a study of limited scope such as this. It could be argued, however, that the two essential requirements of economic growth are: iTax Burdens in 1948," National Tax Journal. IV (September, 1951), 269"85. Also, see Richard A. Musgrave and L. Franc, Rejoinder to Tucker," National Tax Journal. V (March, 1952), 1-14. Rufus S. Tucker."Rebuttal.” National Tax Journal. V (March, 1952), 36-38. Richard A. Musgrave and L. Franc, "Concluding Note," National Tax Journal, V (March, 1952), 39. 81 • • • the willingness of Individuals to devote effort, imagination and capital to increased production, more efficient production and the production of new things, and . . . the supply of capital ready to move into the frontiers of economic development. £Italics in original •'] 3U While economic development depends on numerous economic as well as non-economic factors, yet the most essential prerequisites of economic growth are an adequate supply of capital and more important the willingness of the "centers of initiative" to participate in the risks of economic enterprise. The role of private investment in the operation of a private economy and its contribution to economic growth have been well stated by one author: Private investment maintains and raises the produc tivity of the nation and the standard of living of the people. It helps prevent economic "stagnation," deter mines the severity of business cycles, helps determine the long- and short-run level of employment, and when funneled into large and small business (both old and new), it helps maintain the vigor and growth of our economic system. 31 It appears, therefore, that fiscal operations can affect the supply of capital, the determinants of invest ment (and thus the volume of investment), and thereby eco- I Inomic growth. Taxation, for example, may seriously check ' i Committee for Economic Development, "Taxes and the Budget: A Program for Prosperity in a Free Economy," Read ings in Fiscal Policy, eds., Arthur Smithies and J. Keith Butters (Homewood, Illinois: Richard D. Irwin, Inc., 1955), p. 363. ii JAAnderson, op. cit.. p. 507. 82 the flow of private funds into capital markets. It may also adversely affect the incentive to invest and take risks. Public expenditures (with taxation), furthermore, can influence the rate of economic growth by altering the consumption saving ratio or the rate of capital formation. Certain public expenditures, on the other hand (education, conservation programs, highway construction, and so forth), can affect the potential productivity of the economy by affecting the quantity and quality of resources.^ The preceding analysis was an attempt to show the tremendous impact which the government financial transac tion can exert on the operation of the economy. More precisely, the foregoing discussion intended to show that The literature on economic development in general and those concerning with fiscal policy and economic growth in particular are voluminous. A few outstanding ones, however, are cited here for further references. John H. Adler, "Fiscal and Monetary Implementation of Development Programs," The American Economic Review. XLII (March, 1952) (Supplement), 584-600. V. K. R.V. Rao, "Deficit Financing, Capital Formation and Price Behavior in Under developed Economy," Indian Economic Review, I (February, 1953), 55-91. Richard Goode, "Taxation and Economic Development," National Tax Journal, LXI (March, 1953), 523-35. John M. Clark, "Effects of Public Spending on Capital Formation," Capital Formation and Its Elements (New York: National Industrial Conference Board, 1930), pp. 54-72. Summer Slickter, "Long-term Economic Trends," The American Economic Review. XL (March, 1950) (Supple ment), 457-69. David M. Wright, "The Great Guessing Game: Terborgh vs. Hansen," Review of Economics and Statistics. XXVIII (October, 1946), 18-22. V.“ K. R. V. Rao, "Full Employment and Economic Development," Indian Economic Review, I (August, 1952), 43-57. fiscal policy in general and taxation in particular, if scientifically formulated and effectively administered, can directly or indirectly contribute to the functioning of the economy. Yet, fiscal policy (particularly taxation) is a tool and if carried beyond its limits, can become a danger ous instrument and may impair the operation of the economic system. As has already been shown, American government activities have increased both intensively and extensively over the last few decades. The extensive need for revenue, on one hand, and the fact that taxation can be detrimental to the operation of the economy, on the other hand, has posed an important problem for the American economy and taxpayers. We need taxes, but they must be so arranged as to have the least possible restriction on enterprise, production, and employment. Besides being adequate and equitable, taxation must be kept within its limits. It is the limits of taxation as a fiscal tool and source of revenue which have necessitated that fresh considerations be given to the limits of taxation and taxable capacity-- the subject of our next chapter. CHAPTER IV THE PROBLEMS OF TAXABLE CAPACITY OF THE UNITED STATES The preceding chapter reviewed the development and role of public finance in the American economy. Particular emphasis was placed upon the "net” economic effects of the ‘ government financial transactions on the "basic economic incentives," production, national income, and economic growth. The importance of taxable capacity and the need for fresh analysis of it have already been pointed out. We need only state the essence of the matter and recapitulate some of the relevant factors. The unparalleled increase in the government responsibilities and expenditures in recent years--particularly in the under-developed economies where government is (and perhaps should be) increasingly assigned a far more positive role in the economic arena— has .accentuated the need for larger revenues. Tax policy, if [wisely formulated and effectively administrated, not only i serves as a basic means of financing government outlays; it can also be employed as a very useful and effective device to promote various objectives of national economic 84 85 policy. Taxation, however, is a tool, and like any other tools, if carried beyond its limits can impair "basic" economic activities and thus hamper the operation of the economy. The extensive need for revenues, on one hand, and the fact that taxation could become a dangerous and retard ing device, on the other hand, have made it necessary that more attention be given to the limits of taxation and taxable capacity. Therefore, the rapid expansion of the tax-supported public functions and expenditures has raised a fundamental question, namely, what portion of the nation’s income can be taxed away without generating substantial ill effects on economic activities and the functioning of the economy? This simple, yet fundamental, question has led to the problems of tax limits and taxable capacity. It must be emphasized, however, that the con cept of taxable capacity and tax limits (whether they are defined in economic, political, or psychological terms) is not a new innovation. As will be shown later, the idea of taxable capacity has long been the subject of extensive discussion by many economists of the past. Yet, the recent increase in tax collection with all its economic conse quences has thrown new light on the problem. After all, where the government taxes away more than one-fourth of a nation’s income and where its financial activities have 86 profound effects on the national economy, the question of taxable capacity becomes very pressing. Therefore, this chapter will present: (1) a short history of ideas on taxable capacity, (2) a critical review of the recent analysis of taxable capacity, (3) an examin ation of the taxable capacity of the United States in the light of these considerations, and (4) a very brief analysis of taxable capacity of the so-called under developed economies. I. A FEW PAGES OF HISTORY ON TAXABLE CAPACITY The idea of taxable capacity has long been the sub ject of speculation and extensive discussion. In 1930, for example, Sir Josiah Stamp--the eminent English economist— presented a systematic and extensive discussion of taxable capacity and its determining factors.*- Hugh Dalton, another English economist, also dealt with it quite exten sively. After analyzing the concept and the governing factors of taxable capacity, he made the very important point that taxable capacity is a relative concept depending on time, place, and other factors.^ ^Sir Josiah Stamp, Wealth and Taxable Capacity (London: P. S. King and Son, 1922), Chapter IV. 2 Hugh Dalton, Principles of Public Finance (London: Routledge and Kegan Paul, 1948), Chapters III and V. 87 Yet, it was in 1945 that Colin Clark— the well-known Australian economist— revived the issue of taxable capacity. Clark1s thesis regarding the economic limits of taxation appeared first in a thought-provoking article in the Economic Journal in 1945^ and then was set forth in an article in Harper*s Magazine in 1950.^ His bold conclusion and the fact that the share of government activities in the total economy, particularly that of taxation, had become an increasingly large figure at that time, revived the inter est in the problem of taxable capacity and stimulated extensive discussion of the subject. In a nutshell, Clark argued that once taxation absorbs more than 25 per cent of the national income of non-totalitarian countries in time of peace, then it (actually becomes an engine of inflation rather than its commonly-supposed deflationary effects. It must be noticed, however, that this ratio applies ". . . to ratio of total taxes to national income rather than to the effec tive rate on any one person*s income or property or on any i particular transaction."-* Clark*s conclusion, therefore, ^Colin Clark, ’ ’Public Finance and Changes in the Value of Money," Economic Journal, LV (December, 1945), 371-89. ^Colin Clark, "The Danger Point in Taxes," Harper’s Magazine (December, 1950), 67-69. c Richard Goode, "An Economic Limit on Taxes: Some Recent Discussions," National Tax Journal. V (September, 1952), 227. 88 ”... must be sharply distinguished from the proposal for a constitutional amendment limiting federal income taxes to 25 per cent.”* * In his original article (Economic Journal). Clark ; seems to have explained the tax limits in ’ ’quasi-political” terms. To begin with, while Clark recognizes that changes in the value of money are caused by many factors (such as wars, trade cycle, and so forth), he attempts to show that public finance may in the long run (defined as two or three years) have a decisive effect on the value of money. Therefore, after examining the principal socio-economic factors which may change the value of money, he concludes that: . . . both the causes initiating and terminating such [inflationary or deflationary] movements are most likely to be found in the field of public finance through the operation of (i) deficits or surpluses, (ii) large changes in rate of taxation.' It must be noted, however, that the author seems to place a greater emphasis on taxation as a contributing factor to the changes in the value of money. In fact he points out that ”. . .of much greater importance than the effects of ideficits or surpluses [on the value of money] is the effect 6Ibid. ^Clark, "Public Finance and Changes in the Value of Honey,” p. 373. 89 of taxation itself.”® Then Clark seeks to explain how taxation, if carried beyond this limit, can actually lead to an inflationary movement. Simply stated, he argues that when taxation exceeds 25 per cent of the national income, influential elements in the community transfer their ’ ’allegiances” in the direction of inflation as a means of reducing the burden of interest charges on public debt and other fixed charges in the budget. Once inflation has reduced the burden of budget (in real terms) sufficiently, then there occurs a re-transfer of ’ ’allegiances” among the influential groups in the community in favor of stabilization in the value of money.9 It appears then that Clark's ’ ’original” article emphasizes a ’ ’quasi-political” explanation of the tax limit. In a nutshell, it argues that when the amount of tax collection reaches 25 per cent of the nation* s income, then influential groups— those who more or less direct and influence the national economic policies greatly--in the community favor inflation as a means of reducing the burden of fixed charges in the budget. But once inflation has brought taxes below the critical level and thus has made 8Ibid. 9Ibid., pp. 372-74 90 the burden of the budget more bearable, then they turn to a policy of stabilization. His "quasi-political" thesis of the tax limit is clearly enunciated in the following passage: In cabinets, bank parlours, meetings between em ployers and trade unions, and other places where national economic policies are settled we may expect to find some representatives of those elements in the com munity which favour a stable or rising value of money (fixed income classes and creditors) and some of those elements which favour a falling value of money (debtors and entrepreneurs). If a stable or gradually falling value of money eventuates we can infer that the two parties are in substantial equilibrium. But excessive taxation, levied for payment of interest on public debt, and capable therefore of being relieved (in real terms) by a general rise in prices, may cause a tem porary transfer of allegiance from the deflationary to the inflationary side on the part of a number of poli ticians, bankers, economistsnand others, sufficient to alter the balance of power. To complete his thesis and the mechanism through which the limit of taxation works itself out, Clark con cludes that: When the value of money has been reduced suffi ciently to make the burden of the budget bearable, there will be a re-transfer of allegiances in the political, administrative and banking fields and government authorities and bankers will resume their normal opposition to all proposals which they think would have an unduly expansionist effect; individual employers will show stronger resistances to demands for wage increases; and the general value of money will again become stable. i 1QIbid.. p. 372. • ^Ibid., p. 374. In order to substantiate his thesis and strengthen his analysis, Clark submits a great deal of empirical data on national income and budgetary expenditure of many countries— including France, Belgium, England, Italy, Norway, Germany, Japan, Canada, Australia, New Zealand and many others— from the 1920*s through the 1940's. After a careful comparison of both tax collection and national income data is made, particularly for periods of substan tial changes in value of money, the author maintains that the safe critical limit of taxation is in the vicinity of 25 per cent of the national income. The historical ex perience of those countries examined seems to show that any deviation from the critical limit of tax collection has almost always led to changes in the value of money until the level of taxation has been brought within its safe level. France, for example, in 1926 adopted and maintained such general level of prices as to make the ratio of tax ation to the national income almost exactly 25 per cent for the next four years.in 1934, France found itself in a similar situation and the balance was established in 1938.33 In 1925 the amount of tax collection in Belgium exceeded its limit and consequently devaluation of the 12Ibid.. p. 376 13Ibid.. p. 377 92 money continued until the burden of taxation was reduced to about 18 per cent of the national income.I4 Similar con clusions are drawn from studies of deflationary periods. The severe Italian deflation in 1926, for example, was halted when the level of taxes was raised to about 23 per 1 c cent of the national income. Clark then concludes that: The data appear to give very considerable support to the hypothesis that once taxation has exceeded 25 per cent of the national income (20 per cent or less in certain countries), influential sections of the com munity become willing to support a depreciation of the value of money; while so long as taxation remains below this critical limit, the balance of forces favours a stable, or occasionally an increasing, value of money.16 In his later article (Harper's Magazine). Clark t turns to an economic explanation of the tax limit, by show ing that the anti-inflationary power of taxation is subject to economic limits. While Clark recognizes that deficit spending is inflationary, yet he states that: ... if a government incurs very heavy expenditures, and these are covered by taxation, so that the budget is balanced, the trend— while it may be deflationary for a time— will in the long run [defined as two or three years] be toward inflation if the rate of tax ation is too high to be borne. 14Ibid.. p. 376. 15Ibid.. p. 377. ^^Ibid., p. 380. ■^Clark, "Danger Point in Taxes," p. 67. 93 Thus heavy expenditures covered by taxation--while deflationary at first--will ultimately tend toward infla tion because excessive taxation weakens employers* resist ance to wage increases, encourages wasteful business expenditures, and reduces the amount and the efficiency of work. Consequently, heavy taxation will induce a general rise in the level of prices partly by increasing wages and other costs and partly by undermining incentives to work, to save, to invest and to produce. John Williams, in a Presidential address before the American Economic Associ ation in 1951, enunciated a similar reasoning by stating that when taxes absorb more than a certain percentage of Gross National Product, then it, . . . turns upon itself and, instead of having the deflationary effect intended, becomes an engine of inflation, partly through pushing up wages and other costs and thus pushing up prices to the point where the tax burden, in real terms, has been brought back within the limits of tolerance, and even more through under mining incentives to produce and to save.*° In spite of a great deal of criticisms which were I launched against his thesis, Clark seems to hold his thesis more or less in original form. In fact, in a response to a telegram by Grover W. Ensley, the staff director of the Joint Conanittee on the Economic Report, in January 1952, 18 John Williams, "An Economist’s Confessions," The American Economic Review. Papers and Proceedings, XLII (March, 1952), 18. he pointed out that **. . . all the reasoning and conclu sions of my article in Harper magazine, to the best of my knowledge, still stand. No information which has become available since that date will effect any important alter- 19 ation." 7 He pointed out, however, that 25 per cent is a round figure and the critical limit should be stated **. . . as 24-26 per cent or even 23-27 per cent."^ He also stated that if . . highly regressive taxes are adopted, it may be possible to go -a *few points* beyond the 25 per cent limit without causing prices and incomes to _ t t 21 rise. An Evaluation of Clark*s Thesis The idea that there is a limit to the total tax burden that an economy can bear has been entertained by many economists from time to time. Yet, Clark*s bold con clusions, on one hand, and the fact that many countries were faced with postwar inflation, on the other hand, led to a great deal of speculation about the taxable capacity. We have already examined the essence of Clark*s thesis which first dealt with the political consequences of i •^See Report of the Joint Committee on the Economic Report. 82nd Cong., 2nd sess. (Senate Report No. 1295, February, 1952), p. 316; Goode, op. cit., p. 229. 20Ibid. 2^Ibid. 95 heavy taxation (Economic Journals. and then stressed the economic effects of high tax rates (Harper*s Magazine). In spite of the generally-held belief that there is some limit to the total tax burden which a system of private enterprise can safely bear, Clark*s thesis received a great deal of criticism simply because many believe that there is no single immutable limit. In order to examine the controversial Clark thesis, a brief evaluation is in order. Our evaluation of Clark*s thesis will consist of first examining his statistical evidence and then his theoretical analysis. It must be emphasized that much of Clark*s conclu sions are based on statistical evidence in a number of countries from the 1920*s through the 1940*s. By comparing indexes of retail prices with the ratio of taxes and deficits to national income in a number of countries for various periods, he declares that ". . . the safe political and economic limit of taxation is somewhere around 25% of 'national income.Clark*s statistical evidence of his theory, however, is subject to a number of criticisms. In the first place, his method of comparison of retail price i indexes with the ratio of taxes and deficits to the i national income is somewhat faulty. By comparing these ^Clark, "Danger Point in Taxes,” p. 67. 96 | i two variables (price indexes and the ratio of taxes and deficits to national income), and then correlating them to each other, he assumes that changes in one were the causes of changes in the others. However, it is quite possible that both these variables are determined by changes in the third factor or factors. Therefore, in examining these data, statistics alone cannot be utilized to prove that: ... in the past a tax burden in excess of 25 per cent of national income caused an increase in prices. To prove his case, he would be required to show that other factors were not equally as important as, or more important than, the tax factor.23 Secondly, Clark's own figures do not establish a clear correspondence between taxes and the level of prices. Let us, for example, take the case of France in 1922-38, to which Clark devotes a great deal of attention. He points out that in 1922, "France found herself . . . with taxation absorbing 25% of her national income, and with an uncovered deficit representing a further 8% of national income.”^ Having found this burden intolerable, a devaluation of the franc took place and finally the level of prices was estab lished at the point which made ". . . the ratio of taxation 23Joseph A. Peckman and Thomas Mayer, "Mr. Colin Clark on the Limits of Taxation,” The Review of Economics and Statistics. XXXIV (August, 1952), 233. 2^Clark, "Public Finance and Changes in Value of Money," p. 376. 97 to national income almost exactly 25% for the next four years."2“ * In 1934 France found herself again in a similar situation to that of 1922. While the devaluation of 1936-38 was somewhat different from the previous devalu ation, yet Clark goes on to say that ”... the tendency to settle down with taxation in the neighborhood of 25% of the national income can again be noticed.”2^ After a careful examination of French statistics it appears that: ... in the period 1922 through 1938 there was a con tinuous upward trend in prices, even though taxes plus deficits varied greatly. Except for the high tax ratio in 1928-35, average prices and taxes appear to be in versely rather directly c o r r e l a t e d .27 For example, prices rose 28 per cent from 1925 to 1927, and 37 per cent from 1936 to 1938 even though taxes and deficits combined were less than 25 per cent of national income for these two periods. In contrast, while the ratio of taxes and deficits to national income equalled or exceeded 25 per cent in 1922-24 and 1928-35, yet ’ ’ prices in 1924 averaged almost 25 per cent higher than in 1922, , while prices in 1935 were 7 per cent lower than in 1928.”2® 25Ibid.. p. 377. 26Ibid. 27 Peckman and Mayer, op. cit.. p. 235. 28Ibid.. p. 234. 98 Furthermore, while price increases following 1926 in Belgium seem to conform with Clark*s thesis, yet in 1923 there was a rise in the level of prices even though taxes j land deficits were less than 25 per cent of the national J ! i income. The case of Italy also shows the reverse of Clark’s thesis. "In 1934, when taxes were 30.8 per cent of national income, the price index stood at 342 as compared with 438 in 1928, when taxes were 23.6 per cent."^ After an exhaustive examination of Clark’s sta tistical information, Pechman and Mayer conclude that: : . . . both falling and rising prices can be observed in j different countries even though taxes were at the same j level in relation to national income. ... of all the cases presented by Mr. Clark, in only I two (Great Britain and Norway) do the data support him. But from the fact that in these two countries deflation stopped at a time when taxes fell short of 25 per cent of the national income, it cannot be argued that in flation would have resulted if taxes had gone beyond this limit.30. The changes in the value of money in various periods in question could have been caused by many other factors such as war dislocation, the international currency prob lems, the problem of unemployment, and a host of others. One writer, for example, attributes the 1920’s inflationary pressures to the failure of the reparation negotiations ^Ibid., p. 236. ^Ibid., pp. 235-36 99 91 and to foreign exchange speculation. J Some observers have attributed the deflationary situation in England and Norway to an attempt to return to the gold standard at the prewar parity. Ralph G. Hawtrey seems to attribute the end of the British deflation in 1926 to changes in the American and 9 9 French financial policies.Finally, it seems rather unrealistic to infer, as Clark would have wanted us to do, that the governments could stop the deflation of 1930*s by just letting taxes exceed 25 per cent of national income! The preceding points were only presented to show that changes in the value of money are caused by many factors and if Clark wants to establish his thesis firmly, he must show that other factors were either absent or/and insignificant. Before we turn to an examination of Clark's analytical support of his thesis, it should be mentioned that the post-World War II data which Clark presented in Harper's Magazine conform quite well to his thesis. How ever, as one critic points out Clark's postwar statistics do not show that inflation was more severe in countries where taxation exceeded 25 per cent of national income ^^Eleanor L. Dulles, French Franc: 1914-1928 (New York: The Macmillan Company, 1929), pp. 156-57. ■^Ralph G. Hawtrey, The Art of Central Banking (London: Longmans, Green and Co., 1933), pp. 204-17. 100 oo than other countries. Most observers attribute the postwar inflationary pressure in the United States to post war dislocations, deficit spending during war, liquid asset accumulations, and the postwar "pent-up' 1 demand, rather than to high taxation. Let us now turn to an evaluation to Clark's analysis of the factors which are responsible for heavy taxation to be inflationary. As it has already been indicated Clark's original explanation of the tax limit was formulated in "quasi-political" terms. It was his later article (Harper's Magazine), that emphasized the economic effects of high taxation. Clark's "transfer of allegiance” arguments are sub ject to a number of criticisms. In the first place, the price level is usually determined by numerous nonpolitical factors such as business cycle, the volume of employment, the foreign trade problems, and a host of other factors. Secondly, the proportion of "fixed” public expenditures varies greatly from one country to another without any clear relationship of the ratio of taxes to national : income. Thirdly, even if the influential elements favor i inflation to reduce the real burden of the "fixed” public 33 See the testimony of Professor Walter W. Heller before the Joint Committee on the Economic Report, op. cit., pp. 315-16. expenditures, the advantage of alleviating this burden by inflation in 1920*s and 1930*s seems doubtful since many countries were faced with the balance of payments problems. It is simply clear that inflation increases both export prices and the volume of imports and thus it may deteri orate the balance of trade. Finally, even if some powerful elements in the community switch their allegiance to in flation, it is hard to see why the national average level of taxation should be controlling. It is not unrealistic to assume that the response of any group is probably in fluenced by the average tax liabilities of its own members and not by the national average. So long as tax structure is different among different countries and within the same country, if the ’ ’transfer of allegiance” ever occurs, then it must occur at different levels of average taxes and not at the same level.^ Thus it seems clear that Clark’s ”transfer of allegiance” argument is quite vulnerable on several grounds. In his Harper’s Magazine article, Clark turned to the economic effects of heavy taxation and made clear that the anti-inflationary power of taxation is subject to a number of economic limits. In a nutshell, he pointed out See Peckman and Mayer, o p . cit.. pp. 238-39; Randolph E. Paul, Taxation in the United States (Boston: Little, Brown and Company, 1954), pp. 702-707. 102 that high tax rates impair incentives to work and thus reduces production; excessive taxation weakens employers* normal resistance to wage increases and thus by pushing up wages and other costs will increase prices; heavy taxation and high tax rates induce wasteful expenditures. Although there is some truth in Clark*s contention that high tax rates have some adverse effects on various economic activi ties, a closer examination of the problem reveals that the adverse effects of taxation are not as clear cut as Clark would want us to believe. To begin with the effects of taxation on incentives to work and thus the supply of labor depend on what Lionel Robbins calls ’ ’the elasticity of demand for income in terms qc of effort"-an economic concept on which empirical information is very scanty. While few studies have been made on the effects of taxation on incentives to work of various groups (farmers, laborers, professional men, and so forth), the net effects depend on the form of taxation and the nature of their economic activities. A high retail ■ sales tax, for example, may curtail or postpone the ■^Lionel Robbins, "On the Elasticity of Demand for Income in Terms of Effort," Economica. X (June, 1930), 123-29. For a brief account of the "Harvard Studies" concerning the effects of taxation on various economic activities, see J. Keith Butters, "Taxation, Incentives, and Financial Capacity," Readings in Fiscal Policy. Arthur Smithies and J. Keith Butters, eds. (Homewood, Illinois: Richard D. Irwin, Inc., 1955), pp. 502-18. 103 purchase of taxed goods and thus it might lead to less effort to secure income. The net effects of an increase in direct taxation on activities of lower-income groups are not clear cut. On one hand, if the net income for a sixth day of work is less than the average net income per day for a normal work week, then the "substitution effects'* of taxes may become stronger than their "income effects." On the other hand, while high tax rates may reduce the desire to work, yet the individual's pattern of living with many already created commitments, may actually increase effort so as to reach his "target income." The difference between our desires and what we actually do is often missed by many observers who delve into this problem. The effects of high tax rates on the activities of upper-income groups depend on the nature of their activi ties. For example, if an individual is already enjoying a great deal of leisure, then he may not value additional leisure very highly. Therefore, ". . . as taxes rise the substitution effect [of taxation] may become weaker, and, since income after taxes falls, the income effect See Professor Heller's testimony before the Joint Congressional Committee on the Economic Report, op. cit., p. 319; Peckman and Mayer, o p . cit.. p. 240. 104 37 [of taxation] may become stronger,” So far as high- salaried executives are concerned, ”... organizational pressures and non-pecuniary motivations are likely to maintain efforts during considerable periods.*'38 While high tax rates may restrict the mobility of executives, and their adverse effects may be more serious in the long run, yet one observer concludes that: . . . the economy has not— as a tax consequence— lost a serious amount of services, except in certain areas. . . . For the most part, with considerable exceptions, business men are currently working as hard under high tax rates as they would under low tax rates. . . .3" The reasons that the present tax system has not had a substantial retarding effects on incentive to work and the current amount of working are not far to seek. In the first place, many individuals have little control over the hours of work. Secondly, even in the personally-owned ^Peckman and Mayer, op. cit.. p. 240. It must be also noticed that substitution of leisure for remunerative work should not be considered totally a ”dead economic loss.” If these individuals use their time to engage in certain activities— such as their own gardening and repair i works— while they do not involve monetary rewards and thus they are not entered into the monetary figure for national income, yet they increase the real value of the national income. 38 J Dan T. Smith, ”Note on Inflationary Consequences ;of High Taxation,” The Review of Economics and Statistics. XXXIV (February, 1952), 245. 39 Thomas H. Sanders, Effects of Taxation on Executives (Cambridge, Massachusetts: Harvard University Press, l95l), pp. 12 and 15. 105 enterprises, interruption of operation may jeopardize the success of the business. Thirdly, the importance of the .non-pecuniary rewards, particularly for businessmen and the high-salaried executives, must not be ignored. Fourthly, the effects of taxation on incentives and on business practices depend on the types of taxes used, and on the relation between the average and marginal rates of taxation. It appears that the incentive effects are related to the marginal rate of taxation and have little, if any, relevance to the total tax burden. If it could be proven that high average rate of taxation is always associ ated with high marginal rate, then one could establish a i i stronger case for the incentive effects of taxation. The existence of numerous loopholes in the tax system, on one hand, and the ineffectiveness of tax administration and the level of tax compliance, seem to show a much lower effec tive tax rate than what appears on the tax-rate schedules. Finally, the speed with which tax rates are changed and the expectations of future tax changes undoubtedly affect the incentive effect of taxation. For example, if a tax in- crease is considered to be temporary, the incentive effects |may be very severe; yet, if an increase in the tax rate is considered to be of permanent nature, then people may actually adjust themselves to it without altering the 106 quantity and quality of their economic activities con siderably.40 The purpose of the preceding arguments was not to undermine the economic effects of taxation on incentive to work. It rather intended to focus attention on the fact that the incentive effects of taxation depend on working habits of the individual, nature of his job, size of his family, age of his children, standard of living, the forms of taxes, the relation between the average and marginal rates of taxation and numerous non-economic factors. Clark’s argument that high tax rates weaken em ployers' "normal" resistance to wage increases is also subject to some criticisms. There is some truth in the assertion that an increase in taxation may push up wages and other costs and thereby cause a rise in the level of prices. It is argued, for example, that a rise in excise taxes is reflected in the cost-of-living index which in turn is the basis for wage increases in many instances. Or, a rise in income taxes may lead to wage increases so as to maintain "take-home” pay. In fact the danger that a rise in taxes can lead to wage increases seems to be a real one at the present time, the extent of which, of course, 40Peckman and Mayer, op. cit.. pp. 239-40; Paul, op. cit.. pp. 710-13. 107 depends on the importance of " take-home'* pay in wage determination, the power of labor unions to enforce such policy, the structure of the labor market, the level of employment, the nature of the industry, and a number of other factors. However, it must be pointed out that since the ’ ’ marginal" dollar remaining after taxes is so import ant, the businessmen will guard their profit more force fully so that they can maintain their competitive posi tion. ^ Moreover, while tax increases may lead to wage increases, yet Clark does not seem to show that it becomes operative at the 25 per cent limit.^ Finally, Clark*s contention that high taxation will induce "wasteful" business expenditures is also vulnerable on many grounds. It is true that high tax rates may en courage "wasteful" expenditures, but if profits have already been reduced by high taxation, the remaining profits become more important than ever and businessmen may in fact do whatever possible to protect the remaining i profits. It must be conceded, however, that high tax rates may induce some "nest-feathering" expenditures which may yield a return in future. As one writer points out high i tax rates may "... make it prudent to undertake various ^Goode, op. cit.. p. 230. ^^Peckman and Mayer, op. cit.. pp. 241-42. 1 108 ' i things [such as acceleration of research and development work] which will not produce immediate returns though they are in the long run expected to be profitable.”^ While these expenditures do not reduce the real national income and in fact they may increase it in the long run, they may very subtly produce inflationary pressures by increasing pressures on some scarce resources. Thus, the extent of which high tax rates may encourage "wasteful” business expenditures depends not only on the tax rates but also on the effectiveness of tax administration, the level of tax payer compliance with regulations and numerous other factors. Clark*s more or less universal tax limit then seems to disregard the differences in a country’s political and administrative conditions, degree of compliance, form of taxation and tax rate structure.^ Conclusions to Clark’s Thesis As we have already indicated, Clark* s thesis simply states that high tax rates may fail as an anti-inflationary ^Smith, op. cit., p. 245. ^The inducive effects of taxation on ’ ’wasteful" ,business expenditures are more related to the marginal rates than the average rates. In fact this point was conceded by Clark himself when he stated in his "letter” that it is ". . . the undoubted effect of high marginal rates of income tax on business [that encourage] . . . them to spend money freely on all those fields of expendi tures which are allowed as a deduction for income-tax purposes.” See Goode, op. cit.. p. 232. device--or in fact induce inflationary pressures— for three reasons: (1) it may weaken employers* resistance to the demand for wage increases; (2) it may encourage wasteful expenditures and/or it may induce some ’ *nest-feathering" outlays--while they may increase the real national income in the future, yet may be inflationary presently by exert ing pressures on certain scarce resources; and (3) it may impair incentives and thus by reducing activity and efficiency, lower the volume of production. There is no question that taxation entails many limitations. The relevant question, however, is when and how these factors come into play. The answer to what constitutes a safe tax limit and when the anti-inflationary effects of taxation cease to be operative depends on numerous factors which we have already discussed in the preceding pages. We only want to recapitulate the essence of the arguments and briefly mention the relevant factors. These points are not made to reject the essence of Clark*s thesis; they are only being discussed to show its shortcomings. | For one thing, the effects of taxation on "basic economic incentives" and business practices are not as i simple as Clark seems to propose. The extent and the degree of these effects must still remain conjectural for they are determined by several economic as well as non economic factors. The inducive effects of high tax rates 110 on wasteful business expenditures also depend on the tax rate structure, the quality of tax administration, and the degree of taxpayers* compliance with tax regulation. Whether high tax rates weaken employers* resistance to wage increases must also remain conjectural depending on the types of taxes used, the structure of the labor market, the market structure of the industry, and so forth. Taxable capacity also depends on the level and the nature of government expenditures. If public services augment consumers* welfare and are widely distributed, then it is reasonable to expect a higher taxable capacity. Moreover, the political conditions and the psychological attitude of the people toward public activities tend to influence taxable capacity. Therefore, Clark*s thesis which makes no allowance for the level and nature of public outlays, differences in countries' political and adminis trative conditions and the degree of taxpayers * compliance is somewhat unsecured. Taxable capacity is greatly influenced by the size and the distribution of national income. Clark, however, seems to disregard the absolute size of national income by applying more or less the same limit to countries of dif ferent national incomes. It is commonly held that "Expenditure requiring 10 per cent of the annual income i of India would be much more burdensome than if 30 per cent Ill were to be required in England or the United States."^ Clark’s thesis also seems to be more or less devoid of any attention to the form of taxation and the rate structure. But, as we have already seen, taxable capacity is greatly influenced by the form of taxation and the relationship between the average rate and the marginal rate of taxation. Furthermore, it should be noticed that the revenue system being composed of various taxes seems to indicate that the limit of each tax occurs at a different level. If we conceive of a rising supply curve of taxation--meaning that tax increases, the difficulties of raising additional taxes also increase, since it involves an increasing disutility— then Clark’s universal limit becomes valid only if the supply curve of taxation becomes inelastic at the critical limit.^ However, in the light of the above considerations, it is very unlikely to assume that the critical limit occurs at the same level for all taxes within a revenue system and at the same point in all countries. Clark may argue, of course, that his universal 'critical limit is an average figure, but he should know ^C. F. Bastable, Public Finance (London: Macmillan and Company, 1892), p. 137. lx.fi Arthur Smithies, ’ ’ Federal Budgeting and Fiscal Policies," A Survey of Contemporary Economics, Howard S. Ellis, ed. (Philadelphia: The Blakison Co., 1948), II, 187-224. 112 that averaging in this area is a dangerous business* It has also been pointed out that had Clark formu lated his thesis in terms of public expenditures, he could have made a stronger case for his theory. After all taxation can affect both production incentives and demand. Anti-inflationary taxation becomes less operative only if it reduces production more than demand for goods and 47 services. It appears, therefore, that there exists no uni versal tax limit and no definite limit determinable in advance for any country because of great differences among countries and the relative nature of the governing factors of taxable capacity. The inflationary danger of taxation cannot be disregarded simply ". . . because taxation is below a certain proportion of national income, nor should the fact that taxation exceeds that proportion be a basis for defeatism concerning inflation."48 The complexity of the problem coupled with our imperfect knowledge of many phases of taxation prevent us from any "push-button” type of solution. The question of tax burden and taxable capacity should be carefully examined in the light of many factors which might be at work. It should be concluded therefore that: 4^Smith, op. cit., p. 243 48Ibid., p. 247. 113 Rules of thumb are a lazy man*s expedient for ridding himself of the trouble of thinking and deciding. Experience is a better teacher than theory, but theory is indispensable too. The perpetually changing economic problems of modern life call for a flexible attitude which looks analytically at the past, realistically at the present, and hopefully toward the future with the knowledge that there must be constant adaptation to the new necessities of an expanding economy. 4-9 II. THE TAXABLE CAPACITY OF THE UNITED STATES As it has been shown in the previous chapter, the American taxpayers have been shouldering a tax burden of approximately 30 per cent of national income for the past several years. The increasing tax burden and the fact that some economists ”... have found reason to believe that, as a general rule, 25 per cent of the national income marks approximately the limit of tolerance in a system of private enterprise,”'*® created a great deal of concern over the taxable capacity of the United States. In fact, the Joint Congressional Committee on the Economic Report included the !subject of the United States taxable capacity in its hear ings on the President*s January 1952 Economic Report and its own Joint Committee Report. In a panel discussion which devoted a great deal ^Paul, op. cit., p. 713. 50»t^e Federal Budget and Taxpaying Capacity,” The Guaranty Survey, XXVIII (January 31, 1949), 1. of time to the issue, a number of economists, including Professors Buehler, Friedman, Heller, Miller, Musgrave and Smithies, took part. While the participating econo mists agreed that there is a limit to the capacity of an economy to bear a tax burden, they all criticized Clark's thesis and regarded his critical limit more or less as an "imaginary notion." At the end, the Joint Committee con cluded that: There appears to be some upper economic limit to taxes, although not an inflexible percentage of the nation's income, but an area beyond which further tax increases would aggravate inflation and reduce initiative and output. Some may believe that this limit has been reached. Much evidence was presented to the Committee indicating that the United States has not yet reached the economic limit beyond which an increase in care fully distributed taxes would necessarily prove inflationary. The Committee concurs with this view, although it is concerned both with the burdens already being borne by low-income families and with the adverse effects on incentives and deterrents to venture capital in the high-income brackets.51 Is the present American tax burden unnecessarily burdensome? Does it seriously impair the "basic economic functions," the volume of production and economic growth? A definite answer to these questions is rather impossible for two reasons. First, while there is a general agreement that taxation exerts a profound effect on various economic •^Goode, op. cit., p. 231. 115 activities, yet the extent and the direction of this effect are not clearly known. Second, one's personal reaction to taxes and one's view concerning the proper role of govern ment color and influence one's conclusion. In spite of these difficulties, the answer to the question posed must necessarily depend on a number of considerations. First, we must consider those factors which have been responsible for the expansion of public expenditures and government activities and thus for the rise in taxes. A careful examination of these factors reveals that a great part of increase in public expendi tures and thus tax burden has been more or less of a nature of an "inescapable compulsion." For example, a major pro portion of public expenditures has been the outgrowth of past wars and the present international conditions. More over, the changes in the economic and social system to which government had to respond account for a part of the growth of public outlays. Furthermore, the failure of private enterprise to attain full utilization of resources forced the government to assume a bigger role in the eco nomic arena. The possibility of reducing government expenditures and thus the present tax burden depends partly on the future behavior of these factors and partly upon other factors such as the problem of pressure groups, the organizational set-ups of public agencies and judicious use -’ I 116 of public expenditures. Second, the nature and character of public outlays must be taken into consideration. If public expenditures are so that they would enhance consumers* welfare and are widely distributed, then the burden of taxation would not be as great as if public outlays are greatly unproductive. Third, the composition of the annual tax bill, the nature of taxes and the distribution of the tax burden will indeed affect the burdensomeness of taxation. A care ful formulation of tax policy and an equitable distribution of the tax load will greatly reduce the tax burden. An honest effort must be made to perfect the tax system and bring about the desired changes, but it should be empha sized that ’ ’one of the anomalies of taxation is that the form of the tax system is influenced more by group pres sures and political exigencies than by economic consider ations.”-^ Finally, in determining the burdensomeness of the present American tax system, a greater effort must be made to establish the economic effects of taxation on various -^Lewis H. Kimmel, ”Our Tax Burdens and Taxable Capacity," The Annals of the American Academy of Political and Social Science. 266 (November. 1949). 156. For an interesting account of the role of pressure groups in formulation of tax policy, see Roy Blough, The Federal Taxing Process (New York: Prentice-Hall, Inc., 1952), pp. 18-43'• economic activities— particularly their long-run effects as distinguished from their short-run influences. Even though a number of studies have been made to examine the economic effects of taxation, yet much remains to be desired. The answer to the question of whether the United States economy has reached its limits to bear further taxes must still remain conjectural, depending upon the nature and strength of the preceding factors which govern its taxable capacity. There is no question, however, that government fiscal operations must be conducive to private enterprise system. This calls for a judicious application of fiscal policies, improvement of the tax system and efficient use of public expenditures. A great deal of effort must be made to minimize the tax burden not only to reduce the adverse economic effects of taxation but also because "in these uncertain times a reserve of taxable CO capacity is essential." III. A NOTE ON THE TAXABLE CAPACITY OF UNDER-DEVELOPED ECONOMIES This chapter was mainly concerned with' the taxable capacity of the highly-developed economies, particularly with that of the United States. Yet, the distinctive ~ ^Ibid., p. 160. 118 t characteristics of the under-developed countries— which give their tax and fiscal problems its distinctive character— require that a brief analysis should be made of the responsibilities, needs, and fiscal problems of govern ments of the less advanced countries in relation to their economic development and growth.^ It is commonly recognized that the under-developed countries, . . . are caught in the vicious circle of extreme poverty, a circle proceeding from low incomes to high consumption propensities to low savings to low rates of capital formation to a continuation of low levels of income. Escape from this vicious circle calls, among other meas ures, for a rigorous and positive role by government to initiate, finance, and achieve developmental programs not only to further economic growth directly, but also to 5^A word of caution should be sounded in regard to our classification of economies into ’ ’developed” and ’ ’ under-developed," and regard them as two ’ ’homogenous groups.” The differences in economic, social, and politi cal conditions among the under-developed, or even the developed, countries are often too wide to justify such a broad classification. In spite of these individual differ ences, however, the striking contrast between the majority of the developed countries and the bulk of the under developed economies coupled with the existence of certain common "features" in the highly-developed and the under developed countries might justify our classification. ■^United Nations, Technical Assistance Administra- tion, Taxes and Fiscal Policy in Under-developed Countries (New York: United Nations, Technical Assistance Adminis- tration, 1954), pp. 2-3. 1 119 \ stimulate and strengthen the private sector by providing the necessary economic, social, and political environ ment.^^ The degrees and forms of government participation in the initiation and the direction of the development process, of course, depend on each country’s economic, political and other institutional characteristics. The underlying conditions which exist in the under-developed countries, however, require that government be given a far more positive role in the process of economic, social, legal, and political development. As one writer points out, . . . the state--not necessarily by choice but by necessity--will have to play a larger role in the development of many of the underdeveloped areas today than it did in nineteenth-century Britain and in this country [the United States].57 The "creep" toward more government participation in economic activities in many under-developed countries has been the product of several growing forces. First, there has been a growing "public pressure" for rapid economic growth. "A highly productive technology principally i ; adapted to large-scale organization [which] is available Providing and financing "social overhead capital," for example— which due to its nature must be essentially undertaken by government directly— serves not only as a direct instrument of economic growth, but also as a pre requisite to the better functioning of the private sector. -^Charles J. Walsh, "Foreword," in Edward S. Mason, Economic Planning in Underdeveloped Areas (New York: Fordham University Press, 1958), pp. vi-vii. 1 2 0 for the borrowing. . . . And the tremendous discrepancy in per capita incomes . . . tends to favor strong governmental 58 action.” Secondly, the ”demonstration effect” of public- directed economic development of Soviet Union and China has also tended to favor more public action. Finally, there is a growing recognition that ”... the transition of under developed economies into economies exhibiting a process of sustained growth will require Ta big push' or a 'critical minimum effort.*”59 The so-called ”big-push” thesis simply states that, There is a minimum level of resources that must be devoted to ... a development program if it is to have any chance of success. Launching a country into self- sustained growth is a little like getting an airplane off the ground. There is a critical ground speed which must be passed before the craft can become air-borne.60 Yet, the law per capita incomes, low savings ratios, and the primitive state of capital markets in the under developed countries together with the fact that foreign investment cannot be expected to bear a large part of the costs of capital accumulation, have made the government responsible, at least in the short run, for most of the -*®Mason, on. cit., pp. 14-15. •^Ibid., p. 44. ^^Max Milliken and W. W. Rostow, The Objectives of the United States Economic Assistance Programs (Washington. D.C.: United States Government Printing Office, 1957), p. 70. 12 1 capital accumulation.^ Therefore, . . . the impact of technology on the capital require ments of early development, the public pressure for haste, the ideological predispositions regarding the character of development, the primitive state of domestic capital markets, and the nature of foreign sources of funds--all stack the cards in favor of government as the primary initiator of resource expansion. The growing role of government in promoting economic development without inflation in many under-developed countries has resulted in renewed emphasis on the role of fiscal operations. Since large capital funds are required to accomplish adequate development programs, the problem of securing funds has become a pressing one for the govern ments of under-developed countries. To finance the public development projects several means present themselves of which two will be briefly explained. First, deficit financing can be employed; however, the absence of an ade quate market for public obligations (which forces govern ment to employ inflationary financing through the central bank and other financial institutions) and a number of other characteristics of the under-developed countries-- See Gerald M. Meier and Robert E. Baldwin, Economic Development (New York: John Wiley and Sons, Inc., :1957), Chapters 16, 19, and 20. 62 Mason, op. cit., p. 48. 122 such as high propensity to consume, the production system being not too responsive to demand, and market imperfection--tend to make deficit spending quite infla tionary. ^ Another means by which government can finance its development projects would be an expansion of tax system both intensively and extensively. Several factors, how ever, seem to delimit the extensive use of taxation as the financial source of government activities. In the first place, an extensive use of taxation may have an adverse effect on the political structure of the country. Secondly, the administrative feasibility of taxation also presents a great problem. Thirdly, the possible adverse effects of taxation on the basic economic activities make an extensive use of taxation rather undesirable. Fourthly, some of the prevailing conditions in the under-developed areas determine their fiscal structure and taxable capacity. Since these countries are primarily agricultural and rely heavily on one-product export, then the develop ment of an elaborate tax system, at least at the present, ^John h. Adler, Eugene R. Schlesinger, and Ernest C. Olson, Public Finance and Economic Development in Guatemala (Stanford, California: Stanford University Press, 1951), pp. 210-11. 123 6& is not feasible. Finally, with low per capita income which barely reaches subsistance level for the masses, there is not much for government to lay its hands on. That is perhaps why the share of government in countries with low per capita income (less than $100) usually runs from 6 to about 15 per cent of Gross National Product; whereas in countries with high per capita income ($800 or more), 65 the figure is somewhere between 20 and 30 per cent. In spite of these difficulties, taxation if care fully formulated can be utilized as a partial means of financing government development programs. Without getting into detail, a number of possibilities can be indicated. While progressive income taxation provides an element of equity, yet its possible adverse effects on savings and investment suggest that income taxation should be applied to selected forms of income like land rents. It is pos sible, however, to introduce a greater degree of progres- sivity into the tax system through an inheritance tax. 6& For example, of total revenue of the Salvadorean government in 1946, 53.2 per cent was from taxes on foreign trade and 10*7 per cent from direct taxes. See Henry C. Wallich and John H. Adler, Public Finance in a Developing Country: El Salvador, A Case Study (Cambridge, Massa chusetts: Harvard University Press, 1951), p. 3. Again, of total revenue collected in Guatemala in 1948-49, 65 per cent was in import duties and consumption taxes. See Adler, Schlesinger, and Olson, op. cit.. pp. 49-50. k^Harry t. Oshirna, "Share of Government in Gross National Product for Various Countries," The American Economic Review, XXVII (June, 1957), 381. ; 124 Moreover, a very uneven distribution of the ownership of real property calls for more progressive property tax- 66 ation. To combat excessive speculation and to induce savings into more productive investment channels, a ’ ’selective" type of capital gains tax is also a possi- 67 bility. Finally, while consumption taxes have the advantage of falling on consumptions rather than savings, yet they may lead to price increases and to make the tax structure quite regressive. In order to minimize these disadvantages, however, they may be used selectively, discriminating in favor of necessary commodities and against luxuries. It appears, therefore, that a very large increase in taxation in many of the under-developed countries would probably be very difficult to accomplish for a number of reasons. First, the state of development of these econo mies makes it impossible for the government to absorb a very high proportion of the national income. Secondly, the possible adverse effects of taxation on various economic activities make an extensive use of taxation somewhat undesirable. Yet the great need for revenues by government ^John H. Adler, "The Fiscal and Monetary Imple mentation of Development Programs," The American Economic Review, Papers and Proceedings, XLII (May, 1952), 587-98. ^Taxes and Fiscal Policy in Under-developed Coun tries, p. 36. 125 calls for an increase in tax revenue, if inflationary deficit financing is to be avoided. The solution of this problem lies to a large extent in the formulation of a careful plan of fiscal policy and control. More precisely, it calls for improvement in fiscal administration and formulation of tax policy— that can tap more effectively all sources of revenue--yet be conducive to productive economic activities. Finally, a great deal of effort should be made to develop a capital market government securities so as to supplement taxation for financing development programs. CHAPTER V CONCLUSION The examination of the over-all ratio of public activities to the national income over the last few decades reveals a marked upward trend in both tax payments and public expenditures. Many factors such as international conflicts, the rise of complex social and economic system, business fluctuations, changes in public attitude toward the role of government, and so forth, have been responsible for the growth of public functions and responsibilities. With these growing responsibilities and functions has come the need for larger tax collection and necessity of allocating a larger portion of national income to public activities. The growing share of government of the national income has been viewed with apprehension and alarm by many observers. The reasons for such apprehension are several, yet we may distinguish between two groups whose ideas are very important in distinguishing two aspects of taxable capacity. I One group is concerned with the effects of govern ment diversion of resources (both real and monetary) from 126 127 the private use. It is argued that government withdraws a substantial part of real resources for its use and in addition, through transfer expenditures, it also withdraws an additional share of the current flow of income and distributes it in a manner different from that in which it would otherwise have been distributed. This, it is argued, will not only reduce production for the market (under condition of full employment or/and in short run), but also it may through its "restrictive" effects impair the "basic economic incentives" and thereby directly or indirectly reduce production either from the present level or from a prospective future level. The second group of reasons for an apprehensive attitude toward the growth of public sector is concerned with the mechanism through which government withdraws resources from the private use. It is argued that since government mechanism of withdrawing resources from other uses involves a certain degree of coercion, then the growth of public activities may not reflect the freely-expressed interests of various groups. That is to say that so long as taxation takes the form of compulsory payments for general services, taxes are not directly related to the consumption or enjoyment of services by each taxpayer and therefore the greatest danger of high taxes is the loss of i freedom of personal choice. 128 Thus taxable capacity involves two problems: . . . the problem of taxable capacity as that of diver sion of scarce real resources to governmental uses; and . . . the problem of taxable capacity involving con sideration of the mechanism by which government - agencies divert to their use the necessary fund.1 The pertinent question is how serious are the effects of public activities on the operation and vigour of economy, and how well-founded is the apprehensive atti tude toward the growing share of public activities. How ever fundamental this question may be, no definite answer can be given, for our answer depends on a number of con siderations. In the first place, in determining the net effects of public withdrawal of scarce resources from private uses on the operation of the economy, one must balance the "restrictive” effects of public activities on the performance of the private sector with the "expansive” effects of government activities. However, the determin ation of the net effects of government activities on the operation of economy is a difficult task, for it depends on the nature of public expenditures, the efficiency with which government uses scarce resources, the tax structure, •the tax-rate structure, the quality of tax administration, and many other factors. Simon Kugnets, "National Income and Taxable Capacity," The American Economic Review, XXXII (March, 1942) (Supplement), 42. 129 Secondly, those factors which have been responsible for the growth of public activities must be taken into consideration. We have discussed these factors from time to time and their nature seems to indicate that a great part of increase in public activities is in the nature of i an "inescapable compulsion." As one economist has pointed out, a great deal of growth in public activities has been the "... result, not of caprice, but of deeply tinderlying forces of secular character." Although the future trend of public activities depends on the course which these "secular forces" may take, every expenditure, however fundamental it may be, should not be exempt from careful scrutiny. For, as one writer states: There are, of course, many elements of normality in these increases, but the elements of normality must not be permitted to obscure the abnormal. Obviously the problem is to sort out the normal from the abnormal, the avoidable from the unavoidable if there be such, the desirable from the undesirable.-5 It is true that government needs to have adequate revenues to finance its "essential" and "vital" programs and services, but revenue can be raised only in a vigorous and flourishing economy. Although the economic vitality depends on the nature and strength of economic activities 2Ibid., p. 67. ^Harold W. Guest, "Public Expenditure," Viewpoints on Public Finance (New York: Henry Holt and Co., 1947), p. 544. 130 of various groups, a fiscal system which is capable of achieving its intended objectives without unduly impairing the "basic economic incentives" is imperative. In spite of these considerations, the apprehensive attitudes toward government activities have real substance. It is argued that increasing government activities may ( eventually place a heavy tax burden on the economy which may prove detrimental to free-enterprise and the function ing of the economy. It is true that taxation with its present magnitude serves not only as the basic means of financing the "necessary" and "essential" services of government, but also could be used as a major economic control device to promote various goals of national eco nomic policy. Yet, there are many limitations to the use of taxation as an economic control device and a means of raising necessary revenues for government expenditures. These limits which are of economic, psychological, or political nature have already been examined. Although there must be a range beyond which a tax increase may not only fail to achieve its intended objectives, but also hamper the operation of economy, it is very difficult to measure tax limits and taxable capacity. The basic diffi culty in measuring the capacity of a nation to bear taxes is due to the fact that taxable capacity is not fixed and depends on, 131 ... the levels of national income, the uses being made of expenditures, expected future tax levels, the forms of taxes used, the distribution of the tax load, the quality of tax administration, the rapidity of tax increase, and the international situation, as well as the underlying public attitude toward taxation. . . There is no specific level of taxation applicable to all countries, or at all times to any single country, which may in any absolute sense be referred to as constituting the limit of taxable capacity. But, that such limit exists needs no further elaboration. It is timely, therefore, to conclude that: No one can foretell at what point an annoying burden becomes a fatal deterrent to enterprise; but that such a point exists is beyond question, and wise policy will certainly refrain from putting the matter to test.^ ^Roy Blough, The Federal Taxing Process (New York: Prentice-Hall, Inc., 1952), p. 232. - ’"The Federal Budget and Taxable Capacity," The Guaranty Survey, XXVIII (January 31, 1949), 3. BIBLIOGRAPHY BIBLIOGRAPHY A. BOOKS Adler, John H., Schlesinger, R., and Olson, Ernest C. Public Finance and Economic Development in Guatemala. Stanford, California: Stanford University Press, 1951. Anderson, William H. Taxation and the American Economy. New York: Prentice-Hall, Inc., 1951. Bastable, C. F. Public Finance. London: Macmillan and Co., 1892. Blough, Roy. The Federal Taxing Process. New York: Prentice-Hall, Inc., 1952. Bowman, Mary J., and Bach, George L. Economic Analysis and Public Policy. Second edition. 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"Impacts of Fiscal Policy on National Income," Canadian Journal of Economics and Political Science, VIII (Aiigust 7194277“35F85. ----------------------- Stigler, George J. "A Survey of Contemporary Economics: A Review," Journal of Political Economy, LVII (April, 1949), 97-98. Tucker, Rufus S. "Distribution of Tax Burdens in 1948," National Tax Journal, IV (September, 1951), 269-85. _______. "Rebuttal,” National Tax Journal, V (March, 1952), 36-38. !Wallich, Henry C. "Income-generating Effects of a Balanced Budget," Quarterly Journal of Economics. LIX (November, 1944), 78-91. Williams, John. "An Economist’s Confessions," The American Economic Review, XLII (March, 1952), 1-23. 137 Wright, David M. "The Great Guessing Game: Terborgh vs. Hansen," Review of Economic Statistics. XXVIII (October, 1946), 18-22. C. ESSAYS AND ARTICLES IN COLLECTIONS Adler, John H. "The Fiscal System, the Distribution of Income and Public Welfare," Fiscal Policies and the American Economy. Kenyon E. Poole, editor. New York: Prentice-Hall, Inc., 1951. Pp. 359-409. Butters, Keith J. "Taxation, Incentives, and Financial Capacity," Readings in Fiscal Policy. Arthur Smithies and J. Keith Butters, editors. Homewood, Illinois: Richard D. Irwin, Inc., 1955. Pp. 502-18. Clark, John M. "Effects of Public Spending on Capital Formation," Capital Formation and Its Elements. New York: National Industrial Conference Board, 1930. Pp. 54-72. Committee for Economic Development. "Taxes and the Budget: A Program for Prosperity in a Free Economy," Readings in Fiscal Policy. Arthur Smithies and J. Keith Butters, editors. Homewood, Illinois: Richard D. Irwin, Inc., 1955. Pp. 360-78. Due, John F. "Government Expenditures and Their Signi ficance for the Economy," Fiscal Policies and the American Economy. Kenyon E. Poole, editor. New York: Prentice-Hall, Inc., 1951. Pp. 201-51. Haavelmo, Trygne. "Multiplier Effects of a Balanced Budget," Readings in Fiscal Policy. Arthur Smithies and J. Keith Butters, editors. Homewood, Illinois: Richard D. Irwin, Inc., 1955. Pp. 335-43. Harriss, Lowell C. "Public Finance," A Survey of Con- , temporary Economics. Bernard F. Haley, editor. Vol. II. Homewood, Illinois: Richard D. Irwin, Inc., 1952. Pp. 261-306. Keith, Gordon E. "Repercussions of the Tax System on Business," Fiscal Policies and the American Economy. Kenyon E. Poole, editor. New York: Prentice-Hall, Inc., 1951. Pp. 310-58. 138 Oliver, Henry M. "Fiscal Policy, Employment and the Price Level," Fiscal Policies and the American Economy, Kenyon E. Poole, editor. New York: Prentice-Hall, Inc., 1951. Pp. 99-157. Peck, Harvey W. "The General Theory of Public Expendi tures," Viewpoints on Public Finance. Harold M. Groves, editor. New York: Henry Holt and Company, 1947. Pp. 550-53. Smith, Dan T. "Analysis of Factors Limiting Taxable Capacity," The Limits of Taxable Capacity. Symposium conducted by the Tax Institute. Princeton: Tax Insti tute, Inc., 1953. Pp. 3-15. Smithies, Arthur. "Federal Budgeting and Fiscal Policies," A Survey of Contemporary Economics. Howard S. Ellis, editor. Vol. II. Philadelphia: The Blakison Co., 1948. Pp. 187-224. Wald, Hackell P. "Fiscal Policy, Military Preparedness and Postwar Inflation," Readings in Fiscal Policy. Arthur Smithies and J. Keith Butters, editors. Homewood, Illinois: Richard D. Irwin, Inc., 1955. Pp. 155-69. D. PUBLICATIONS OF THE GOVERNMENT, LEARNED SOCIETIES, AND OTHER ORGANIZATIONS Guaranty Trust Company of New York. "The Federal Budget and Taxable Capacity," The Guaranty Survey, vol. 28, no. 10. New York: Guaranty Trust Company of New York, 1949. Milliken, Max, and Rostow, W. W. The Objectives of the United States Economic Assistance Programs. Washing ton, D.C.: United States Government Printing Office, 1957. National Industrial Conference Board. The Economic ; Almanac. New York: National Industrial Conference j Board, various years. Tax Foundation. Facts and Figures on Government Finance: 1958-59. New York: Tax Foundation, Inc., 1958. 139 United Nations, Technical Assistance Administration. Taxes and Fiscal Policy in Under-developed Countries. New York: United Nations, Technical Assistance Administration, 1954. United States Congress, Senate, Joint Committee on the Economic Report. Hearings before Joint Committee, 82d Congress, 2d session, on S. 1295, February, 1952. Washington, D.C.: United States Government Printing Office, 1952. United States Treasury Department. Treasury Bulletin. Washington, D.C.: United States Government Printing Office, 1958. bn Versify of Southern California LM srarjs

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Asset Metadata

Creator Hezareh, Ali (author)

Core Title An economic analysis of taxable capacity and its determining factors with special reference to the United States

Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, General,OAI-PMH Harvest

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Anderson, William H. (committee chair), Elliott, John E. (committee member), Garis, Roy L. (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c20-449736

Unique identifier UC11265660

Identifier EP44781.pdf (filename),usctheses-c20-449736 (legacy record id)

Legacy Identifier EP44781.pdf

Dmrecord 449736

Document Type Thesis

Rights Hezareh, Ali

Type texts

Source University of Southern California (contributing entity), University of Southern California Dissertations and Theses (collection)

Access Conditions The author retains rights to his/her dissertation, thesis or other graduate work according to U.S. copyright law. Electronic access is being provided by the USC Libraries in agreement with the au...

Repository Name University of Southern California Digital Library

Repository Location USC Digital Library, University of Southern California, University Park Campus, Los Angeles, California 90089, USA