The Power to Tax: Analytical Foundations of a Fiscal Constitution

Geoffrey Brennan.
Brennan, Geoffrey and James M. Buchanan
(1919- )
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Indianapolis, IN: Liberty Fund, Inc.
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1. Geoffrey Brennan and James M. Buchanan, The Power to Tax: Analytical Foundations of a Fiscal Constitution (New York: Cambridge University Press, 1980), volume 9 in the series.

2. James M. Buchanan, Public Finance in Democratic Process: Fiscal Institutions and Individual Choice (Chapel Hill: University of North Carolina Press, 1966), volume 4 in the Collected Works.

3. The initial summary statement of the central analytics was in article form. See Geoffrey Brennan and James M. Buchanan, "Towards a Tax Constitution for Leviathan," Journal of Public Economics 8 (December 1977): 255-73; see also volume 14 in the series, Debt and Taxes.

4. For example, Geoffrey Brennan and James M. Buchanan, "The Normative Purpose of Economic 'Science': Rediscovery of an Eighteenth-Century Method," International Review of Law and Economics 1 (December 1981): 155-66, and Geoffrey Brennan and James M. Buchanan, "Predictive Power and Choice among Regimes," Economic Journal 93 (March 1983): 89-105; both articles are in Economic Inquiry and Its Logic, volume 12 in the series. Geoffrey Brennan and James M. Buchanan, The Reason of Rules: Constitutional Political Economy (Cambridge: Cambridge University Press, 1985), volume 10 in the series.

5. Anthony de Jasay, The State (Oxford: Basil Blackwell, 1985); republished by Liberty Fund in 1998.

Chapter 1

6. John Rawls, A Theory of Justice (Cambridge: Harvard University Press, 1971). This setting was also used in a context perhaps more closely related to our analysis in James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962).

7. James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975).

8. Social-choice theorists have attempted to define reasonable properties that might be expected for a "social" or "governmental choice function." However, all such efforts have foundered on the central contradiction involved in any shift from the preference or value rankings of a single person to an ordering designed to reflect the potential choice bases for a group or community of persons. The focal point for much of the analysis in social-choice theory has been Arrow's famous impossibility theorem. The theorem demonstrates that no social-choice function based on individual evaluation can exist that does not violate one or more of the reasonable conditions or properties imposed on such a function at the outset. See Kenneth Arrow, Social Choice and Individual Values (New York: John Wiley & Sons, 1951). In our terminology, government cannot, even conceptually, work "perfectly" because there is more than one person or citizen affected by its operation. That pattern of governmental activity deemed to be "perfect" by Mr. A might be deemed just the opposite by Ms. B or Mr. C.

9. Both Lord Hailsham and Professor Hayek have recently argued strongly to the effect that the presumption is invalid. See Lord Hailsham, The Dilemma of Democracy (London: William Collins Sons & Company, 1978); and F. A. Hayek, Law, Legislation and Liberty, vol. 3, The Political Order of a Free People (Chicago: University of Chicago Press, 1979).

10. Knut Wicksell, Finanztheoretische Untersuchungen (Jena: Gustav Fischer Verlag, 1896).

11. See Buchanan and Tullock, The Calculus of Consent.

Chapter 2

12. The monopoly-state models developed by several Italian public-finance theorists have some common features with our construction. These models were presented alternatives to the democratic-state models by both de Viti de Marco and Fasiani. For a general discussion of the Italian contributions, with appropriate citations of the relevant Italian works, see James M. Buchanan, "La scienza delle finanze: The Italian Tradition in Fiscal Theory," in Fiscal Theory and Political Economy (Chapel Hill: University of North Carolina Press, 1960), pp. 24-74.

13. Dennis H. Robertson, Economic Commentaries (London: Staples Press, 1956), pp. 148-49, 154.

14. See James C. Miller III, "A Program for Direct and Proxy Voting in the Legislative Process," Public Choice, 7 (Fall 1969), 107-13.

15. See the discussion of the "punishment dilemma," in Buchanan's The Limits of Liberty (Chicago: University of Chicago Press, 1975), chap. 8, and the discussion in Buchanan's paper, "The Samaritan's Dilemma," in Altruism, Morality and Economic Theory, ed. E. S. Phelps (New York: Russell Sage Foundation, 1975), pp. 71-85.

16. In a constitutional choice, the desired level of welfare payments will be that level which maximizes the expression:

whereas period-by-period decision making will produce the result

where Bi is aggregate dollar benefit in period i and Ci is aggregate dollar cost in period i.

17. For an attempt to model this problem for the individual formally, see A. M. Shefrin and Richard Thaler, "An Economic Theory of Self-control," Working Paper No. 208, Center for Economic Analysis of Human Behavior and Social Institutions (Stanford, Calif.: National Bureau of Economic Research, October 1977).

18. In a setting where individual sovereignty is accepted, the precise normative authority of constitutional as opposed to in-period preferences is by no means clear. One cannot say whether the one should take precedence over the other without appeal to additional value judgments. One can, however, at a purely positive level, observe that decisions about in-period outcomes may be taken at the constitutional level that would never emerge out of ordinary political process, whatever the electoral rules, because in-period preferences would not endorse them. By their nature, such constitutionally preferred policies (including potentially much of redistributional policy) must emerge independently of current electoral processes.

19. Anthony Downs, An Economic Theory of Democracy (New York: Harper & Brothers, 1957), chaps. 11, 13.

20. That is, they will possess less than Pareto-optimal levels of information.

21. This is, in essence, the argument typically put in favor of governmental decision making, rather than decision making by means of continual referenda. The absence of continual referenda does, however, undoubtedly lead to greater discretionary power held by bureaucrats and politicians.

22. To secure single peakedness in preferences, substantial restrictions on both the domain of public spending and the permanence of tax institutions would be required, restrictions that need not characterize the "fiscal constitution."

23. See Downs, An Economic Theory of Democracy, chap. 10.

24. Ibid.

25. Suppose, to take a simple case, that party I distributes $280 randomly between two voters (let them be A, B), the identity of whom is unknown to party II, and retains the remaining $20 for itself. To establish the proposition that choice of this strategy does not reduce to zero party I's chances of winning, all we need to ask is whether party II can be certain of victory if it distributes the full $300 to the electorate. The answer is clearly no. If II distributes $150 to either B or C and nothing to A, I will win if he pays more than $150 to either B or C and the remainder to A. Party I's offer could be (120, 160, 0), and II's (0, 150, 150); and I would win the election. There is clearly a whole range of possible arrangements in which I defeats II, even though the sum of the payoffs to electors is smaller for party I.

26. Downs, An Economic Theory of Democracy, chap. 10.

27. Political appointees may populate the upper echelons of the bureaucracy (as they do in American institutions), in which case they may be constrained in much the same way as politicians are (or are not) by electoral proceedings, depending on their tenure. But in some parts of the bureaucracy (the military establishment, for example) and in all parts of the bureaucracy where the executive is officially apolitical (as in British institutions), bureaucrats are not at all subject to electoral constraints—whether those constraints are effective or not.

28. William Niskanen, Bureaucracy and Representative Government (Chicago: Aldine-Atherton, 1971).

29. The importance of this role is emphasized and an interpretation of Niskanen's theory along such lines offered in ongoing work by our colleagues Robert Mackay and Carolyn Weaver. See, for example, their "Monopoly Bureaus and Fiscal Outcomes: Deductive Models and Implications for Reform," in Gordon Tullock and Richard E. Wagner, eds., Deductive Reasoning in the Analysis of Public Policy (Lexington, Mass.: Lexington Books, 1978); "Agenda Control by Budget Maximizers in a Multi-bureau Setting," Public Choice (Summer 1981), forthcoming; "Commodity Bundling and Agenda Control in the Public Sector: A Mathematical Analysis," Virginia Polytechnic Institute and State University Working Paper CE 79-6-1; and "On the Mutuality of Interests between Bureaus and High Demand Review Committees," Public Choice, 34 (1979), 481-91. See also Arthur Denzau and Robert Mackay, "Benefit and Tax Share Discrimination by a Monopoly Bureau," Journal of Public Economics (1980). For an analysis of constitutional limits as a control on the monopoly power of agenda setters, see Arthur Denzau, Robert Mackay, and Carolyn Weaver, "Spending Limitations, Agenda Control and Voters' Expectations," National Tax Journal, 32 (June 1979), 189-200; and "On the Initiative-Referendum Option and the Control of Monopoly Government," Papers of the Committee on Urban Public Economics, 5, 1980.

30. A Rawlsian fiscal constitution could be devised in which the rules that we develop would play a role. But this is not what we have attempted here. Such an effort would, however, represent a promising line of inquiry.

31. Such reasoning does not, of course, rule out the possibility of redistribution entirely. Where altruistic attitudes prevail, or where for other reasons "donors" derive benefits from transfers that are not fully excludable, redistribution through the public sector may be thoroughly justified on efficiency grounds over some range. What the reasoning does rule out is the neutrality of transfers that are purely random in terms of the directions that citizens desire. In other words, transfers that are zero-sum when the redistributive process is costless are negative-sum in practice. The constitutional contract would naturally seek to minimize these negative-sum elements.

32. See Gordon Tullock's pathbreaking paper "The Welfare Costs of Tariffs, Monopolies, and Theft," Western Economic Journal, 5 (June 1967), 224-32; also see Richard A. Posner, "The Social Cost of Monopoly and Regulation," Journal of Political Economy, 83 (August 1975), 807-27, and Anne O. Krueger, "The Political Economy of the Rent-seeking Society," American Economic Review, 64 (June 1974), 291-303. These basic papers, along with other contributions to the general theory of rent seeking, are collected in Toward a Theory of the Rent-Seeking Society, ed. James Buchanan, Robert D. Tollison, and Gordon Tullock (College Station: Texas A&M University Press, 1980).

Chapter 3

* Some of the central ideas developed in this chapter were initially presented in a more general format in our paper "Towards a Tax Constitution for Leviathan," Journal of Public Economics, 8 (December 1977), 255-74.

33. Modern public-choice theory has incorporated the effects of tax instruments on public-goods supply in a constitutional choice approach. Almost exclusively, however, the public-choice model for constitutional fiscal choice has embodied the assumption, explicitly or implicitly, that postconstitutional budgetary decisions conform to the public-goods demands of the median voter or his representative in a legislative assembly. For this approach, see James M. Buchanan, Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967). The analysis in this book differs critically from the public-choice theory analysis, in that we substitute a revenue-seeking Leviathan for the demand-driven and essentially passive government which that analysis assumes.

34. If the spending side of the account is taken into account, the ideally efficient tax becomes the Lindahl tax price. In one sense, the element of coercive taxation is removed in this "fiscal-exchange" approach. The latter approach is, however, not properly classified as falling within the orthodox tax analysis summarized here. For a discussion of the fiscal-exchange approach, as it is contrasted with the orthodox, see James M. Buchanan, "Taxation in Fiscal Exchange," Journal of Public Economics, 6 (July-August 1976), 17-29.

35. In its most general meaning, "efficiency" must be related to conceptual agreements among all members of the community. At the level of standard policy discussion, it is relatively easy to translate the familiar Paretian criterion into such consensual terms, especially when the possibility of actually organizing a set of compensations is allowed. In constitutional choice, however, the consensual definition of efficiency (i.e., an efficient position or rule is one upon which no agreement for change can possibly be reached) does not readily map into familiar concepts in modern welfare economics. An "efficient" tax arrangement, one that would emerge from agreement at a constitutional state of deliberation, need not, and normally would not be expected to, satisfy orthodox criteria for efficiency defined at the in-period or postconstitutional level.

36. There are evident similarities between our model and that developed by William Niskanen in his theory of bureaucracy. See his Bureaucracy and Representative Government (Chicago: Aldine-Atherton, 1971).

37. In the most extreme setting for constitutional choice, we may assume that the individual is in some Rawlsian "original position" and behind the "veil of ignorance." See John Rawls, A Theory of Justice (Cambridge: Harvard University Press, 1971). We do not need to impose such rigid requirements, however, for the constitutional setting to be relevant. Somewhat more plausibly, we may assume only that the individual is highly uncertain about his own future position. See James M. Buchanan and Gordon Tullock, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962).

38. The use of tax constraints to ensure that the value of a will be high will be specifically analyzed in Chapter 7.

39. The interrelationships among G macron, a, and various aspects of tax institutions will be discussed in some detail in Chapter 4.

40. The analysis holds equally for the case where the comparison is between a more comprehensive and a less comprehensive base, even when the former is itself less comprehensive than the "ideal," when defined in the orthodox terms.

41. By the assumptions of the model, the individual cannot predict his precise preference pattern as between money-income-earning and alternative activity in postconstitutional periods. All that is required for our analysis here is that these preferences are predicted to be standard.

42. It should perhaps be noted at this point that we are assuming that the revenues collected, as these accrue to the agents of government, are not included in the comprehensive base of the tax itself. In the simple conception of Leviathan as the ruling class or monarch, the assumption here is tantamount to allowing the king to be exempt from taxation. In a dominant majority conception of political process, the comprehensive tax may be presumed to fall on all income, but not on the special benefits, transfers, and so on, that accrue to members of the majority coalition as a result of disbursements from total revenues collected.

43. The construction in Figure 3.1 can be used to demonstrate how the constitutional choice setting under our political assumptions transforms the familiar excess-burden argument made in support of a comprehensive tax base. A solution at point K, in the traditional argument, is shown to be inferior to that which might be attained with a comprehensive base or general tax that will yield the same revenue, producing an ideal solution at a point such as H in Figure 3.1, which may lie on a higher indifference curve than K. This argument must presume, however, that the government, once empowered to levy the comprehensive base tax, will, in fact, restrict its attempt to raise revenue to the collections dictated by the equi-yield comparisons.

The partial equilibrium version, based on the Marshallian demand-curve construction, can be used to illustrate the revenue-maximizing regressive rate structure, but because of income-effect feedbacks on demand, more restrictive assumptions must be made. For similar reasons, the area under the demand curve cannot accurately reflect consumer or taxpayer surplus; nor can the standard welfare triangle measure welfare loss accurately, except in the case where the income-consumption curve in Figure 3.1 is a horizontal line. We set such problems as these aside in the analysis here since they have no particular relevance to our discussion.

44. For an explicit discussion in such an externality setting, see James M. Buchanan, "Externality in Tax Response," Southern Economic Journal, 33 (July 1966), 35-42.

45. Algebraic derivation of the conditions under which different results apply is presented in the appendix to this chapter.

Chapter 4

46. Or an intertemporally neutral "income tax" of the type recommended by J. S. Mill, Principles of Political Economy (London: Longmans, Green, 1926); Irving Fisher and Herbert W. Fisher, Constructive Income Taxation (New York: Harper & Brothers, 1942); W. D. Andrews, "A Consumption Type or Cash Flow Personal Income Tax," Harvard Law Review, 87 (April 1974), 1113-88; and most recently by James E. Meade, The Structure and Reform of Direct Taxation, report of a committee chaired by J. E. Meade (London: George Allen & Unwin, 1978).

47. See W. Corlett and D. Hague, "Complementarity and the Excess Burden of Taxation," Review of Economic Studies, 21 (1953-54), 21-30; Arnold Harberger, "Taxation, Resource Allocation and Welfare," in National Bureau of Economic Research/Brookings Institution, The Role of Direct and Indirect Taxes in the Federal Revenue System (Princeton: Princeton University Press, 1963), pp. 25-70; Abba Lerner, "On Optimal Taxes with an Untaxable Sector," American Economic Review, 60 (June 1970), 284-96; and W. J. Baumol and D. F. Bradford, "Optimal Departures from Marginal Cost Pricing," American Economic Review, 60 (June 1970), 265-83.

48. There is, of course, an exactly analogous horizontal equity argument applicable in all cases except where tastes are identical. See Geoffrey Brennan, "Second-Best Aspects of Horizontal Equity Questions," Public Finance/Finances Publiques, 27, no. 3 (1972), 282-91. Of course, the precise policy implications for horizontal equity will in general differ from those for efficiency (unless all individuals have homothetic preferences) because goods that may be complementary with leisure at the margin will not be complementary with leisure over the entire range.

49. On the other hand, an arbitrary set of excises is worse in an expected sense than a uniform tax on all goods (excluding leisure). Thus, if the complement-substitute relations are not known, uniformity of rates is to be preferred. See Y. K. Ng, "Towards a Theory of Third Best," Public Finance/Finances Publiques, 32, no. 1 (1977), 1-15; and G. Brennan and T. G. McGuire, "Optimal Tax Policy under Uncertainty," Journal of Public Economics, 4 (February 1975), 205-9.

50. We ignore the intersection above and to the left of F, although its existence has been a source of some controversy in the literature on tax progression and leisure consumption. See Robin Barlow and Gordon R. Sparks, "A Note on Progression and Leisure," American Economic Review, 54 (June 1964), 372-77; and John G. Head, "A Note on Progression and Leisure: Comment," American Economic Review, 66 (March 1966), 172-79.

51. The linearity assumption is, of course, special. We should note, however, that this assumption is embedded in conventional measures of excess burden; by examining only first- and second-order terms in the relevant Taylor series expansion of the utility function, those measures of welfare loss are in fact only linear approximations. See note 7 below.

52. Conventional measures of excess burden focus on the second term of a Taylor series expansion of utility functions. That is, if we can represent individual utility functions as

U = f (X1, X2, ... , Xn),

which on manipulation can be shown to yield

[See Harberger, "Taxation, Resource Allocation and Welfare"; and Harold Hotelling, "The General Welfare in Relation to Problems of Taxation and of Railway and Utility Rates," Econometrica, 6 (July 1938), 242-69.] By taking higher terms of the Taylor series expansion, one can of course get more accurate measures of utility change. This is tantamount to allowing for differential curvature of demand (or marginal valuation) curves. So doing would permit a ranking of equi-maximum-revenue taxes according to total welfare loss but would involve measuring "excess burden" with a degree of refinement not used elsewhere in the literature and would in any case involve dealing with a high order of "smalls."

53. See David B. Johnson and Mark V. Pauly, "Excess Burden and the Voluntary Theory of Public Finance," Economica, 36 (August 1969), 269-76.

54. See Joan Robinson, The Economics of Imperfect Competition (London: Macmillan, 1933), chap. 15.

55. Although not among consumers or over units of output; see below.

56. There is no interpersonal analogue to complementarity-substitutability relations between commodities.

57. As elsewhere, the demand curves and the marginal evaluation curves for X are taken to be identical—we abstract from income effects—strictly for analytic convenience.

58. For an early analysis of the analogous construction depicting a private monopolist's profit-maximizing quantity discount offers, see James M. Buchanan, "The Theory of Monopolistic Quantity Discounts," Review of Economic Studies, 20 (1952), 199-208.

59. Note that the rate structure is violently progressive in the neighborhood of Qs, but regressive elsewhere.

60. Harberger, "Taxation, Resource Allocation and Welfare," sec. 4.3.

Chapter 5

61. It can, of course, be argued that the full discounting of future tax liabilities that is required for full Ricardian equivalence is psychologically and empirically unrealistic, and hence that policy analysis should not be based on it. See James M. Buchanan, "Barro on the Ricardian Equivalence Theorem," Journal of Political Economy, 83 (April 1976), 337-42.

62. For our criticism of this basic theorem, see Geoffrey Brennan and James M. Buchanan, "The Logic of the Ricardian Equivalence Theorem," Finanzarchiv, Heft 38/1 (1980), 4-16.

63. We set aside at this stage any limits on taxpayer behavior caused by the recognition that some proportion of revenue is spent on public goods which would otherwise not be provided. This is entirely reasonable if we bear in mind that the taxpayer in question is one among many, each of whom will rationally "free-ride" by avoiding taxes.

64. The game may be depicted as follows:

Leviathan's strategy
Taxpayer's strategy Confiscatory levy Nonconfiscatory levy

Save something [5,20] [15,10]
Consume everything [10,0] [10,0]

where the taxpayer's payoff is the first-mentioned in the pair and Leviathan's payoff is the second-mentioned. Since the confiscatory levy is dominant for Leviathan, the taxpayer consumes everything.

65. So, too, would a tax on income measured in the Haig-Simons manner, sometimes referred to as the "net-accretions" conception or definition of income.

66. It is also an aspect that most conventional "indexing" schemes for income-tax rates ignore. The simple rate-adjustment process as practiced in Canada and Australia cannot handle this problem.

67. Surplus is a proportion (1 - a) of (maximum) revenue, where a is the proportion of revenues collected that must be spent on public goods.

68. Both axes reflect maximum revenue in each period scaled down by the factor 1 - a.

69. Under the consumption-tax arrangement, the locus of potential equilibria in Figure 5.2 is A'B', so that the locus of potential revenue receipts is AB minus A'B', or A'B' (since the maximum revenue consumption rate is 50 percent). Thus, the consumption-tax revenue combination lies somewhere along the line AV in Figure 5.4, and this will lie inside IQ, unless the maximum revenue under the capital tax (B'S' in Figure 5.3) is less than interest on A'A, depicted as QK in Figure 5.4. It is conceivable that B'Q in Figure 5.2 exceeds B'S' in Figure 5.3, but it is not by any means necessary and indeed seems somewhat unlikely. We have drawn it this way in Figure 5.3. In any case, it is clear that for this to be a utility-maximizing possibility for Leviathan, the taxpayer must save a great deal, so that the superior efficiency of the individual as a saver offsets the revenue loss due to the removal of the income-capital tax combination.

70. Leviathan may be able to compel individuals to buy bonds, or by use of tax or other concessions induce them to do so. We do not examine coerced purchase here.

71. See the discussion in Chapter 9 on possible tax exportation within a constitutional choice perspective.

Chapter 6

72. It is evident that any "opening" of the economy tends to place limits on the power of government to create money, quite apart from constitutionally imposed constraints. The revenue-maximizing rate of inflation could be expected to be lower in the presence of competing monies, simply because domestic monopoly power is reduced. See F. A. Hayek, The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies (London: Institute of Economic Affairs, 1976).

73. For a discussion of the necessity of repurchase or its equivalent in a wholly different analytical context, see Boris P. Pesek and Thomas R. Saving, Money, Wealth and Economic Theory (London: Macmillan, 1967).

74. It would also be possible to imagine a situation in which government printed only "period 1 monies"—that is, money that explicitly is legal tender only for a specified period. The capital value of such a money stock would presumably be the value of the transaction services it provides over the period of its legality. In the case of the example cited here, this period 1 value would presumably be rM. There are some interesting aspects to a regime of annual monies, not the least of which is that it seems to deprive government of any possible benefits from inflation. However, money as we know it is a durable asset—a stock, not an annual flow of transactions services—and all our discussion here is predicated on that fact.

75. We do not imply here that the "land" resource as defined in this model has a real-world counterpart. Our purpose is to isolate those features of a resource that may assist in explaining the money-creation power.

76. This assumes that the additional price obtained over the range up to Q* compensates government for the interest it forgoes in postponing the receipt of revenue from the sale of extra units. For example, in period 1, Leviathan could either release Q1 units at price L1, aiming to release an extra (Q2-Q1) units next period, or could release all Q2 units at price L2. In the former case, it obtains

in period 1 values, because it has to wait until period 2 to obtain the revenue from the extra (Q2-Q1) units. In the latter case it obtains

in period 1 values. The former will exceed the latter only if

Q2(L1 - L2 > r (L2Q2 - L1Q1).
In the range above L*, the right-hand side of (3') is positive and may exceed the left-hand side. If so, Leviathan will move instantly to (L*, Q*) and proceed to add successive units beyond Q*. In this range, the right-hand side of (3') is negative, so that (3') always holds.

77. The same capitalized price can be determined by asking the question: What is the present capitalized value of the revenue that the government obtains under an inflation rate, i, if the real money stock held each period is M macron? Now

and is measured in some real numéraire. The real revenue that government obtains in each period is rM by virtue of interest on M that it does not have to pay, plus iM by virtue of deflating the real liability that money represents. This revenue stream is in terms of some real numéraire and must be capitalized by the real rate of return to yield to

78. This solution is emphasized by Milton Friedman, "The Optimum Quantity of Money," in The Optimum Quantity of Money and Other Essays (Chicago: Aldine-Atherton, 1969), pp. 1-50.

79. Our analysis in this chapter has both points of similarity and points of difference with the "rational-expectations" models that have been developed in modern macroeconomic theory. (See Thomas Sargent and Neil Wallace, "Rational Expectations and the Theory of Economic Policy," Journal of Monetary Economics, 2 (April 1976), 169-83; and R. E. Lucas, "Econometric Testing of the Natural Rate Hypothesis," in O. Eckstein, ed., The Econometrics of Price Determination Conference (Washington, D.C.: Board of Governors of the Federal Reserve System, 1972). Like economic orthodoxy generally, these models do not contain a specific objective function for government, although implicitly, government is considered to be interested in promoting the standard macroeconomic policy goals. The models concentrate attention on the prospect that the individual will be able to act on the same information that is available to government; hence, government cannot independently influence behavior in a way that is not subsequently validated. Government cannot "fool the people." Our revenue-maximizing Leviathan does have a specific maximand, and the fully "rational" citizen-taxpayer may know what this is, but such knowledge cannot eliminate the strategic aspects of the interaction between the individual and government, as our analysis indicates. For example, if the individual predicts that Leviathan will adopt the revenue-maximizing permanent rate of inflation and acts on this prediction, Leviathan will find it to its own interest to inflate beyond such limits. To our knowledge, the only specific critique of the rational-expectations literature that concentrates on these strategic aspects is that by Gerald P. O'Driscoll and Andrew Schotter, who do not, however, model government in Leviathan terms. See Andrew Schotter and Gerald O'Driscoll, "Why Rational Expectations May Be Impossible: An Application of Newcomb's Paradox," Discussion Paper, Center for Applied Economics, New York University, November 1978.

80. See Chapter 5, note 3.

81. For a discussion of this point that has some similarity to our treatment, see Larry A. Sjaastad, "Why Stable Inflations Fail: An Essay in Political Economy," in Inflation in the World Economy, ed. Michael Parkin and George Zis (Manchester, England: Manchester University Press, 1976), pp. 73-86.

We should note that a shift from a high rate to a low rate of inflation may, for a short period, increase rather than decrease government's revenue-raising potential in money creation. If the shift causes persons to expect higher values of the money unit, they will seek to increase money balances. Government may, temporarily, gain more from the increased money creation dictated by a response to this demand than it loses by the initial shutdown or slowdown of the presses. On this point, see Gordon Tullock, "Can You Fool All of the People All of the Time?" Journal of Money, Credit and Banking, 4 (May 1972), 426-30.

82. Harry G. Johnson, "A Note on the Dishonest Government and the Inflation Tax," Journal of Monetary Economics, 3 (July 1977), 375-77.

83. See Martin Bailey, "The Welfare Cost of Inflationary Finance," Journal of Political Economy, 64 (April 1956), 93-110; P. Cagan, "The Monetary Dynamics of Hyperinflation," in Milton Friedman, ed., Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956), pp. 25-117; and Edward Tower, "More on the Welfare Cost of Inflationary Finance," Journal of Money, Credit and Banking, 9 (November 1971), 850-60.

84. Bailey, "The Welfare Cost of Inflationary Finance," pp. 93-94.

85. Tower, "More on the Welfare Cost of Inflationary Finance."

86. Geometrically, we could derive the Bailey "revenue-maximizing rule" by taking the rate at which Dm is tangential to a rectangular hyperbola that has as its vertical and horizontal axes the ordinate and zero-inflation or $1 line, respectively, in Figure 6.3. The true revenue-maximizing rate is determined where Dm is tangential to a rectangular hyperbola that has as its vertical and horizontal axes the ordinate and abscissa, respectively, in Figure 6.3. The latter rate must lie below Bailey's, since the latter hyperbola lies everywhere below the former.

87. For a more lengthy treatment of this topic by one of the authors, see James M. Buchanan, Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967), chap. 10.

88. See Edmund S. Phelps, "Inflation in the Theory of Public Finance," Swedish Journal of Economics, 75 (March 1973), 67-82; and Jeremy J. Siegel, "A Note on Optimal Taxation and the Optimal Rate of Inflation," Journal of Monetary Economics, 4 (April 1978), 297-305.

89. The position of Arthur Burns is in sharp contrast with that suggested here. At an American Enterprise Institute conference in mid-1979, Burns indicated support for tax or fiscal rules while holding fast to his familiar opposition to monetary rules.

Chapter 7

** We published a preliminary version of this chapter as "Tax Instruments as Constraints on the Disposition of Public Revenues," Journal of Public Economics, 9 (June 1978), 301-18.

90. A third element determining the overall efficiency of the public expenditure, over and beyond both the level and the disposition, is the composition of budgetary outlay as among separate components. We do not discuss this element explicitly, although our analysis does have implications that are relevant.

91. "It was found, on one occasion, that nearly half the money that had been voted for the Dutch war had gone to the 'corporal pleasures' of the most religious and gracious king—see Pepys's Diaries, a.d. 1666, Sept. 23 and Oct. 10." Footnote in "Edinburgh Review and the 'Greatest Happiness Principle,' " Westminster Review, 22 (October 1829). Reprinted in Utilitarian Logic and Politics, ed. Jack Lively and John Rees (Oxford: Clarendon Press, 1978), p. 184. The author of the Westminster Review essay is presumably not known.

92. In a Niskanen model, Leviathan achieves its surrogate equivalent of "surplus" by producing excessive quantities of G. See William Niskanen, Bureaucracy and Representative Government (Chicago: Aldine-Atherton, 1971). The model has been subjected to criticism precisely because it fails to allow for any diversion of revenues away from the financing of genuine public goods. See Jean Luc Migué and Gérard Bélanger, "Toward a General Theory of Managerial Discretion," Public Choice, 17 (Spring 1974), 27-42.

93. Given the second-order conditions implied by the shapes of CC' and NN' in Figure 7.1 (i.e., d2B*/dG2 < 0).

94. There is an analogy of sorts between such an arrangement as that described here and the return of bloc grants or revenue shares to local units based on "fiscal-effort" criteria. The purpose in the two cases could, however, scarcely be more opposed. With the fiscal-effort criteria, the purpose is to ensure that local governments levy sufficiently high taxes on citizens. With our model, by contrast, the underlying purpose is to ensure that tax money is expended on public goods rather than on bureaucrats' perks.

95. Although their normative emphasis is quite different from that of this chapter, Atkinson and Stern introduce the complementarity between public goods and the tax base as a determinant of the allocatively optimal budget. See A. B. Atkinson and N. H. Stern, "Pigou, Taxation, and Public Goods," Review of Economic Studies, 41 (April 1974), 119-28.

96. Earl Thompson, "Taxation and National Defense," Journal of Political Economy, 82 (July-August 1974), 755-82.

97. In this general sense, it is clear that the analysis is related to the discussion and analysis of the capitalization of public-goods benefits and taxes into land values, especially in the context of a set of local governments among which persons may move.

98. See James M. Buchanan, "The Economics of Earmarked Taxes," Journal of Political Economy, 71 (October 1963), 457-69. Also see James M. Buchanan, Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967), especially chap. 6.

Chapter 8

99. For a general discussion of the fiscal constitution, see Kenneth W. Dam, "The American Fiscal Constitution," University of Chicago Law Review, 44 (Winter 1977), 271-320.

100. For a discussion of the legal-constitutional asymmetry in the treatment of taxes and benefits, see David A. Tuerck, "Constitutional Asymmetry," Papers on Non-market Decision Making, 2 (1967), 27-44.

101. See Harold Hochman and James Rodgers, "Pareto Optimal Redistribution," American Economic Review, 59 (September 1969), 542-57, for a discussion of this possibility.

102. The phenomena discussed here need not be restricted to "environmental regulation," even if this rubric is broadly and inclusively defined. All that is required is that, at some stage of the legitimization argument, appropriate reference is made to "public interest" sufficient to surmount minimal legal standards of acceptance. In his important paper "Taxation by Regulation," Bell Journal of Economics and Management Science, 2 (Spring 1971), 22-50, Richard A. Posner stressed the internal subsidization aspects of such things as the regulation of rail passenger service, local airline service, and natural gas pricing.

Chapter 9

103. Charles M. Tiebout, "A Pure Theory of Local Government Expenditures," Journal of Political Economy, 60 (October 1956), 415-24.

104. David Friedman has analyzed a regime of competitive revenue-maximizing nations, with costless migration, but with attractiveness related to population density. See his "A Competitive Model of Exploitative Taxation," mimeographed, Virginia Polytechnic Institute and State University, August 1979. See also Dennis Epple and Allan Zelenitz, "Competition among Jurisdictions and the Monopoly Power of Governments," Working Paper, Graduate School of Industrial Administration, Carnegie-Mellon University, March 1979.

105. Does Hong Kong offer a real-world example? Interestingly, we observe little or no fiscal exploitation of Hong Kong citizens by the Hong Kong government.

106. For a clear example, see Albert Breton, "A Theory of Government Grants," Canadian Journal of Economics and Political Science, 31 (May 1965), 175-87. But also see Gordon Tullock, "Federalism: Problems of Scale," Public Choice, 6 (Spring 1969), 19-29; Mancur Olson, "The Principle of 'Fiscal Equivalence,' " American Economic Review, 59 (May 1969), 479-87; Albert Breton and Anthony Scott, The Economic Constitution of Federal States (Toronto: University of Toronto Press, 1978); Richard A. Musgrave, "Approaches to a Fiscal Theory of Political Federalism," in National Bureau of Economic Research, Public Finances: Needs, Sources, and Utilization (Princeton: Princeton University Press, 1961), pp. 97-122; and Charles M. Tiebout, "An Economic Theory of Fiscal Decentralization," in Public Finances: Needs, Sources, and Utilization, pp. 79-96.

107. For further discussion, see James M. Buchanan, The Limits of Liberty (Chicago: University of Chicago Press, 1975). Also, see Robert Nozick, Anarchy, State, and Utopia (New York: Basic Books, 1974).

108. Historically, of course, federalized political structures have emerged from some coordination between previously independent units rather than from the deliberative dispersal of political power at a constitutional stage of decision. For our purposes, however, the conceptualization of the latter model of origination of federalisms is more helpful analytically.

109. Earl Thompson has implied that protective-state services are directly related to "coveted wealth." From his argument a case can be made for allowing a central government to tax nonhuman wealth, presumably with designated rate limits. See Earl Thompson, "Taxation and National Defense," Journal of Political Economy, 82 (July-August 1974), 755-82. Thompson derives his theory from the predicate that governments are totally efficient and entirely constrained to produce results desired by the electorate. Our alternative model of public choice generates a quite different normative evaluation of the wealth tax. (See Chapter 5.)

Chapter 10

110. Our use of minimax, however, seems more justifiable than that of Rawls because we are explicitly modeling the behavior of the "adversary player," the Leviathan government, rather than "nature," which presumably distributes talents and capacities with no malign intent.

111. For a specific discussion of this adage, see James M. Buchanan, Public Finance in Democratic Process (Chapel Hill: University of North Carolina Press, 1967), chap. 5.

112. F. A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960).

113. F. A. Hayek, Law, Legislation and Liberty, vol. 3, The Political Order of a Free People (Chicago: University of Chicago Press).

114. We should note that the political structure that Hayek is implicitly suggesting be modified is one of parliamentary government, akin to the British structure. His suggestions for change fit less readily into the U.S. context.

115. For a comprehensive analysis of the effects of extensions in the time sequence of tax rules on the prospects for securing agreement among persons, see Antonio Pinto Barbosa, "The Constitutional Approach to the Fiscal Process: An Inquiry into Some Logical Foundations," Ph.D. Dissertation, Virginia Polytechnic Institute and State University, 1978.

116. For a general discussion of tax limits in the context of the 1978 issues, see Geoffrey Brennan and James M. Buchanan, "The Logic of Tax Limits," National Tax Journal, 32 (June 1979), 11-22.

117. This theme is developed at length in James M. Buchanan and Richard E. Wagner, Democracy in Deficit (New York: Academic Press, 1977).

End of Notes

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