Monday, January 04, 2010

Adam Smith, the Adam Smith Institute, and flat taxes

The Adam Smith Institute is in favour of moving UK income tax to a flat-tax regime. Yet, as Paul Sagar argues below, there are strong reasons to doubt whether a flat-tax regime would have been endorsed by Adam Smith himself, whose views on the distribution of the tax burden appear more progressive than a flat tax on incomes allows for.

However by employing Smith’s name, the Adam Smith Institute implies that the founder of modern economics advocated their tax policies, thereby providing them with an authoritative intellectual legitimacy they may not in fact possess.


The right-wing think tank the Adam Smith Institute (ASI) is in favour of the UK adopting a “flat tax”: see its report, A flat tax for the UK – A Practical Reality. Such a move would be revolutionary. It would overturn a decades-long consensus that higher earners are subjected to higher tax rates than those who earn less.

Flat tax is an example of a 'proportionate' tax: all taxpayers incur the same rate, regardless of income. So, if the rate were 22% (as the ASI suggest) everyone would pay that much, regardless of whether they make £15,000 or £10billion. This is usually attended, however, with the important caveat that a personal tax-free allowance is given to everybody. The ASI advocates a threshold of £12,000 (a bit less than twice the existing personal allowance), below which no tax is paid. Above that everyone incurs the same rate.

This can be compared with “progressive” taxation: as income rises above certain thresholds, the rate at which it is taxed increases. The UK currently has a “progressive” taxation system, so for example once somebody earns more than £37,400, every pound over that threshold is taxed at 40%, but nobody pays tax on the first £6,475 they earn.

Yet if he were alive today, which system would Adam Smith himself have favoured?

Smith’s seminal Wealth of Nations contains a sustained discussion of taxation. But it does not address income tax, because it didn’t exist in his lifetime. Smith does, however, talk about other taxes, and examining what he says is revealing.

Particularly instructive is Smith’s discussion on the maxim of 'equality', and his thoughts on taxing house rents:

“The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”
“The principal objection to [window taxes on houses] is their inequality, and inequality of the worst kind, as they must frequently fall much heavier upon the poor than upon the rich. A house of ten pounds rent in a country town may sometimes have more windows than a house of five hundred pounds rent in London; and though the inhabitant of the former is likely to be a much poorer man than that of the latter.”

These passages seem to put Smith in the progressive tax camp: he clearly believes that the rich ought to pay more than the poor. Yet things aren’t so simple. Such passages only show that Smith thought the rich should pay more tax in absolute terms, not that they should incur higher rates. These lines are compatible with flat tax.

But there is more:

“A tax upon house-rents, therefore, would in general fall heaviest upon the rich; and in this sort of inequality there would not, perhaps, be any thing very unreasonable. It is not very unreasonable that the rich should contribute to the public expence, not only in proportion to their revenue, but something more than in proportion.”

This passage is important. Smith’s sentiment is being applied not just to house rents, but to contributions towards the “public expence” generally. It is a statement that the rich ought to contribute “something more than in proportion”. It could be equally well expressed by saying that the rich should incur higher rates of taxation, not just pay a bigger total. And this seems straightforwardly incompatible with a flat tax regime, where all contribute to the public purse in equal proportion (albeit minus an initial tax-free allowance). It looks like Adam Smith wouldn’t have supported a flat tax for the UK: he wanted the rich to pay “something more than in proportion”.
Why does this matter? By calling itself the Adam Smith Institute, the ASI implies that its policies are sanctioned by the founder of modern economics: these are not just tax policies, these are Adam Smith tax policies. Compare, for political effect, “The Adam Smith Institute” vs. “The Right Wingers for Lower Taxes Institute”.

Moving the UK to a flat-tax regime would be revolutionary. It would overturn the consensus that the better-off contribute, as Smith wrote, “something more than in proportion”. We must ask tough questions of a think tank which uses Smith’s name to promote radical changes to our society and economy that he himself probably wouldn’t have supported.


Blogger Physiocrat said...

Smith seems to have been against taxes on labour altogether, so he would certainly have been against a flat tax.

His "Inquiry" advocated a tax on the rent of land. ASI published a pamphlet by John Loveless in 1987, in which land value taxation was advocated, but has never subsequently advocated the idea. ASI really has little to do with Adam Smith, it is just packaging for a simplistic kind neo-libertarianism more prevalent in the USA.

A few of Smith's ideas have been picked up by these people and given the status of religious dogma. Thus it was that ASI gave us the lunatic scheme for the fragmentation of the railways, based on Smith's observations of pin manufacture in eighteenth century Birmingham, a model that was also adopted for the NHS.

People's reading of Smith is selective!

Wasn't the flat tax dropped in Estonia?

1:58 pm  
Blogger Els Keytsman said...

This 'institute' is nothing but a right wing think thank. I consider them not a research institute since their "research" on fair trade.


3:42 am  
Blogger Tim Worstall said...

Sadly Paul you've missed a very important point. The difference between marginal rates of taxation and average rates.

A flat tax with no personal allowance is indeed not progressive. Everyone pays the same marginal and average rates.

A flat tax with a personal allowance (of whatever sum) is not progressive on marginal tax rates (above that allowance) but is progressive on average tax rates.

Some simple arithmetic. Under the ASI proposals in come of £10,000 has an average tax rate (that is, the tax rate on all income) of 0 %.

An income of £24,000 has an average tax rate of 11% (22% on the £12,000 over the allowance). An income of £36,000 has an average tax rate of near incomes rise average tax rates approach 22%.

We thus have rising average tax rates: we have a progressive tax system, one in which the higher incomes pay more in proportion to their income.

Further, the higher the allowance the more progressive a flat tax becomes. Indeed, this particular proposal, with it's high allowance, wprks out as a little more progressive than our current income tax system by some calculations.

5:33 am  
Blogger Physiocrat said...

One advantage of a standard rate of tax above the threshold is that it makes administration much simpler, as there is not the need for such accurate tax returns when some income has tax deducted at source.

The 10p rate was a confounded nuisance from that point of view.

Nobody should pay tax unless they are earning more than the Minimum Wage. Actually the burden falls on employers and pushes up gross labour costs, thereby promoting unemployment. Not good.

12:12 pm  
Blogger Tomaž Štih said...

You missed three very important points made by Adam Smith.

1. He was strong oponent of income tax in general.

2. He indeed thought that more productive elements of society should pay more. And so they do under flat tax. It A earns twice the salary of B then A pays twice the tax.

But the most important argument is the third one. He argued against arbitrary taxation and that every one shoul pay in proportion to what he gains from the existence of the government. And that is exactly the opposite of progressive tax.

For progressive tax is arbitrary. It is the majority voting that minority will pay higher taxes then they are willing to pay themselves. And the argumentation for it is not a proportion to what ones benefits from the state but arbitrary assumption about the value of money to those taxed. It is not a tax equal for every euro earned (within a governed community as contribution to government) but a tax that arbitrary changes due on some other criteria such as distributive justice.

2:39 am  
Blogger Physiocrat said...

@Tomaž Štih

"1. He was strong oponent of income tax in general."

Smith said nothing on the subject, so far as I am aware. He was against taxation on the wages of labour, flat or otherwise.

"2. He indeed thought that more productive elements of society should pay more."
Where did he say that? Or are you interpreting?

"He argued against arbitrary taxation and that every one shoul pay in proportion to what he gains from the existence of the government."

Which means what, precisely? Arguably, it means a tax on the rental value of land (which he expressly argued for), because it is government that protects and uphold titles to land ownership.

6:27 am  
Blogger David Friedman said...

"It is a statement that the rich ought to contribute “something more than in proportion”."

No it is not. It is a statement that a tax which results in their doing so is "not very unreasonable." He isn't saying that a more than proportional tax is desirable but that it is tolerable.

You have to remember that the quote supporting proportional taxation is the first of his maxims of taxation.

Physiocrat responds to:

"1. He was strong oponent of income tax in general."


"Smith said nothing on the subject"

Smith offers arguments against taxes on the income from capital, against taxes on wages, and against taxes on the income from professions. The only tax on income he approves of is a tax on the income of government officials. So although he doesn't, so far as I know, discuss the idea of a general income tax, he does come out against taxes on most forms of income.

5:38 pm  
Blogger Physiocrat said...

Smith appears to have broken down "income" by distinguishing between the different means by which income arises. This is right, because they cannot be lumped together. There is income from the wages of labour, for example, and income arising from the rent of land. He was opposed to the former but in favour of the latter.

His was not the first or the last word on this subject. The Physiocrats, writing a few years before Smith, pointed out that all taxes are ultimately at the expense of land rent, and for that reason they argued that all the complexities of contemporary tax systems should be done away with and replaced by a single tax on the rental value of land. The case still stands. It has never been conclusively refuted.

The same argument was developed in the context of the changes from an agrarian economy to an urban industrial one by the economist Henry George, reinforcing the Physiocrats' case.

"Benefits gained under the protection of the government" can be nothing other than land titles and their value to those who hold them. What else could Smith have been referring to?

12:56 am  

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