Adam Smith critiques the Deficit Reduction Commission

What would Adam Smith have said about the Bowles-Simpson economic report last week?

What a pity the great free marketer was not around to serve on the Deficit Reduction Commission. He not only would have rolled over in his grave, he would have risen up wielding an ax to the fiscal proposals that are diametrically opposite to the fiscal principles that he and his original free market contemporaries urged.

Writing in the wake of the French Physiocrats with their Impôt Unique to collect the revenues that France’s landed aristocracy drained from the countryside and towns, Smith endorsed the idea that the least burdensome tax was one that fell on land rent:

A more equal land-tax, a more equal tax upon the rent of houses, and such alterations in the present system of customs and excise as those which have been mentioned in the foregoing chapter might, perhaps, without increasing the burden of the greater part of the people, but only distributing the weight of it more equally upon the whole, produce a considerable augmentation of revenue.

(Wealth of Nations, Book V.3.68)

If Britain were to become a dominant economic power, Smith argued, its industrial capitalism would have to shed the vestiges of feudalism. Groundrent charged by its landed aristocracy should be taxed away, on the logic that it was the prototypical “free lunch” revenue with no counterpart cost of production. He noted at the outset (Book I, ch. xi) that there were “some parts of the produce of land for which the demand must always be such as to afford a greater price than what is sufficient to bring them to market.”

In 1814, David Buchanan published an edition of The Wealth of Nations with a volume of his own notes and commentary, attributing rent to monopoly (III:272n), and concluding that it represented a mere transfer payment, not actually reimbursing the production of value. High rents enriched landlords at the expense of food consumers – what economists call a zero-sum game at another’s expense.

The 19th century elaborated the concept of economic rent as that element of price which found no counterpart in actual cost of production. and hence was “unearned.” It was a form of economic overhead that added unnecessarily to prices. In 1817, David Ricardo’s Principles of Political Economy and Taxation elaborated the concept of economic rent. Under conditions of diminishing soil fertility in the face of growing demand, value was set at the high-cost margin of production. Low-cost producers benefited from the rising price level. Ricardo helped clarify the concept of differential rent by applying it to mining and subsoil wealth as well as to land. Heinrich von Thünen soon added the more helpful concept of rent-of-location (site value).

The important classical point was that economic rent was produced either by nature or by special privilege (“monopoly”), not labor effort. Hence, it was that element of price that could not be explained by the labor theory of value, except by marginal costs on what Ricardo hypothesized to be “rentless land” as recourse was made to poorer soils. Ricardo’s follower John Stuart Mill explained that being income without labor or other costs, such rent formed the natural basis for taxation.

The Progressive Era developed the view that public utilities and other natural monopolies rightly belonged in the public sector, where governments would provide their basic services at a subsidized price or even freely as in the case of roads. The idea was to keep user fees no higher than the actual cost of production, so as to avoid rent seeking. This pejorative term means extracting income by placing tollbooths on the economy’s key infrastructure. To leave roads and railroads, electric and power utilities in private hands ran the risk of private owners “rack-renting” the population, adding to the cost of living and doing business.

U.S. policy is just the opposite. Commercial real estate has been regressively “freed” from taxes – leaving the rental value to be pledged to banks as interest. This un-taxing of land rent has been a major factor inflating the real estate bubble on credit, much as deregulating monopolies has helped inflate their stocks and bonds on credit.

This is the policy that the Bowles-Simpson Deficit-Reduction Commission endorses. Its regressive tax proposals would shrink the economy, pushing it further into debt. This transfer of revenue from labor and business to property owners – and from them to their bankers and bondholders – threatens to force up the government’s fiscal deficit (as states and municipalities are seeing today) and turn the United States into a Third World type neofeudal economy.

Smith: Wars should be financed on a pay-as-you-go basis, not by borrowing
If the shade of Adam Smith were to reappear today, he would be equally disturbed by the failure of the Bowles-Simpson commission to address the issue of war debts dealt. Smith’s argument against waging foreign wars was basically an argument that they were not worth the debt burden and the associated taxes to pay interest on it. These payments transferred income from taxpayers to creditors – largely foreign creditors, the Dutch in Smith’s day, Asians today.

Neither Bowles-Simpson nor President Obama acknowledge the extent to which the federal debt – and indeed, most of America’s rise in foreign debt for decades on end – has stemmed from overseas military spending. During the Vietnam War years of the 1960s and ‘70s, the military deficit accounted for the entire rise in U.S. foreign debt, as private sector trade and investment was exactly in balance.

Smith wrote that even a land tax could not finance governments or “compensate the further accumulation of the public debt in the next war.” His argument was that to free the economy from taxes, nations should avoid wars. And the best way to do this was to wage them on a pay-as-you-go basis. Borrowing rather than taxing led the population not to feel the real cost of war – and thus deterred it from making an economically informed choice.

So the Bush-Obama administration has taken a fiscal stance diametrically opposed to that of the patron saint of free enterprise. While escalating war in Afghanistan and maintaining over 850 military bases around the world, the administration has run up the national debt that Smith decried. By shifting the tax burden off property and off rent-seeking monopolies – above all, off the financial sector – this policy has raised America’s cost of living and doing business, thereby undercutting its competitive power and running up larger and larger foreign debt.

The Wealth of Nations traced the growth of Britain’s national debt, listing how each new war borrowing was secured by a new excise tax. Writing in the wake of the Seven Years War with France, fought largely over their respective possessions in the New World, Smith urged Britain to free its American colonies. In a similar vain after France’s Revolution, its Minister of the Navy, Bertrand de Molleville, wrote that Louis XVI in 1792 had blamed the overthrow of his monarchy on the burdensome taxes levied to finance the War with Britain in America.

This did not prevent a new wave of Franco-British war under Napoleon, and by the time this new wave of warfare ended in 1815, interest charges absorbed some three-quarters of British government revenues, and devastated French finances as well as well. Led by Henri de Saint-Simon, French free marketers focused as much on freeing economies from interest-bearing debt as the Physiocrats had sought to tax the landed nobility.

The balance of the 19th century saw a move throughout Europe to endorse progressive taxation. The aim was not class warfare to take from the rich to give to the poor. Led by the industrial middle class and its leaders, the aim was to make national economies more competitive by freeing them from economic rent and private bank credit.

Landlords and bankers were the two rentier classes bequeathed by Europe’s feudal epoch: a hereditary aristocracy receiving land rent simply by virtue of the privilege of birth and ownership, and banking based increasingly on securing the monopoly of credit creation as a means of extracting interest. Pressure grew to socialize the land’s rental value and financial systems so that the economic surplus created by monopoly privilege and the rise in national prosperity would form the natural tax base, not excise taxes on consumer goods and incomes that increased the cost of living (and hence the break-even costs of labor) and of capital.

None of this classical free market theory is to be found in the Bowles-Simpson commission. It advocates a continued shift of the tax burden off property and the wealthiest layer of the population onto labor, and a fiscal giveaway to the vested interests. This is not what the classical economists meant by a free market. Their idea was to free markets from rent and interest, not to dismantle government power to tax and regulate prices to keep them in line with socially necessary costs of production.

So where are the “real” conservatives and free marketers today? They have been dropped from the academic curriculum. This virtual censorship is what enables the public media not to call the Bowles-Simpson commission what it is: a travesty of free market theory.

The way that Adam Smith would have addressed the deficit would have been, “Mr. Obama, pull out of Afghanistan – and perhaps 850 of our foreign bases.” And the century of free market economists who followed Smith would have said, “Tax away unearned rentier income. And do not pay creditors by selling off the public domain to rent-seeking privatizers erecting tollbooths on the economy.” That was precisely the legacy of feudalism that free-market theory was designed to reject, after all.

In view of the conspicuous absence of true free market conservatives, it is clear that President Obama selected members of the Bowles-Simpson commission to provide a rationale – or at least a rhetorical cover story – for turning the U.S. economy into a neofeudal economy increasingly indebted to creditors, enjoying their revenue and “capital” gains (mainly land-price gains that John Stuart Mill’s generation called the “unearned increment”) at the top of the economic pyramid.

It won’t work. It will drive the economy further into debt, shrink the fiscal base and further polarize the economy between rentiers (for whom John Maynard Keynes proposed euthanasia) and wage earners.