Public Finance in Democratic Process: Fiscal Institutions and Individual Choice
By James M. Buchanan
- Ch. 1, Introduction
- Ch. 2, Individual Demand for Public Goods
- Ch. 3, Tax Institutions and Individual Fiscal Choice
- Ch. 4, Tax Institutions and Individual Fiscal Choice
- Ch. 5, Existing Institutions and Change
- Ch. 6, Earmarking Versus General-Fund Financing
- Ch. 7, The Bridge Between Tax and Expenditure in the Fiscal Decision Process
- Ch. 8, Fiscal Policy and Fiscal Choice
- Ch. 9, Individual Choice and the Indivisibility of Public Goods
- Ch. 10, The Fiscal Illusion
- Ch. 11, Simple Collective Decision Models
- Ch. 12, From Theory to the Real World
- Ch. 13, Some Preliminary Research Results
- Ch. 14, The Levels of Fiscal Choice
- Ch. 15, Income-Tax Progression
- Ch. 16, Specific Excise Taxation
- Ch. 17, The Institution of Public Debt
- Ch. 18, Fiscal Policy Constitutionally Considered
- Ch. 19, Fiscal Nihilism and Beyond
Part II. The Choice Among Fiscal Institutions
The economist does not know, and should not know, and should not be concerned as to whether his theories, his models, his instruments or research, serve or should serve a few, many, one, or none at all. If they are not correct, others will expose the errors, modify them, perfect them.—Luigi Einaudi, in his Inaugural Lecture
for the academic year 1949-50 at Torino.
Cited by Aldo Scotto in “Luigi Einaudi,”
Economia Internazionale, XV (February, 1962), 35.
The Levels of Fiscal Choice
In Part II an attempt will be made to examine the individual’s choice among fiscal institutions, as institutions. This level or stage of individual choice behavior, which may be called “constitutional,” differs from that discussed in Part I as well as from that which has concerned traditional public finance theorists. The three separate levels or stages of individual fiscal choice should be explicitly distinguished.
Individual Choice Behavior in Traditional Public Finance Theory—Individual Responses in Market Choice to Imposed Fiscal Patterns. In the orthodox approach, the individual does not make either public-goods choices, as considered in Part I, or institutional choices, to be considered in Part II. Or, to state the same thing somewhat differently, these choices are not normally investigated. The fiscal and the institutional choices for the collectivity of individuals are assumed to be made externally to the individual’s own potential choice system. He is presumed able to choose only in his private market behavior as he reacts to the various tax-expenditure mixes under institutional structures that are externally imposed upon him. The behavior of the individual, as choice-maker, remains the center of analysis, but it is the individual’s private choice among market alternatives, as the latter are modified by the imposed fiscal structure. A typical problem posed in traditional public finance theory is: Given the institution of the personal income tax for raising government revenues, and given the level of rates that are imposed, how will the individual’s choice in allocating his time between work and leisure be made, and how will this choice be influenced by a change in the level of tax rates or by a switch to an alternative institution?
Individual Choice Behavior Under Given Fiscal Institutions—Individual Responses in Fiscal-Collective Choice Under Imposed Fiscal Institutions. In the discussion of Part I, we moved one stage or level beyond the traditional emphasis on market-choice reactions of individuals. In a democratic political order, individuals also
choose the amount of public goods and services that the community will purchase and supply to its citizens. The individual, along with his fellows, makes public-goods choices as well as private-goods choices. The institutions through which these choices are organized may influence his behavior. An attempt was made to analyze this choice behavior and to predict the direction of effect exerted by a few of the commonly observed institutions of modern fiscal systems in democratic countries. For purposes of this analysis, the institutions themselves were assumed to have been selected externally to the individual’s own choices. A typical problem under the approach of Part I is: Given that revenues are to be raised through a progressive tax on personal incomes, how will this fiscal institution influence the individual’s choice in allocating resources between public goods and private goods?
Individual Choice Behavior in Selecting Among Fiscal Institutions. Under a democratic political order, individuals do more than choose in the marketplace and participate in collective choice under given institutions. Ultimately, at some “constitutional” stage of decision, they must also select or choose the structural framework for choice itself; they must choose the institutions under which both day-to-day market choices and ordinary political choices are implemented. It is extremely important that the separate levels or stages of individual choice be considered separately. We may, as in traditional public finance or as in Part I, examine the effects that the institution of the personal income tax exerts on an individual’s behavior in either the marketplace or the voting booth. But at some “earlier” stage of decision, we may also examine his behavior in selecting the particular institution of the income tax over other revenue-raising alternatives. At this level of analysis, we try to compare the personal income tax with other institutions, say, the corporation income tax. For the approach of Part II, a typical problem is: How will the reference individual choose among the several possible alternative tax institutions through which he will exercise ordinary fiscal choices as to the amount of resources devoted to public goods and services?
The Interdependence of Choice
There are three levels of fiscal choice. The individual asks himself: First, how will I choose to pay for the collective goods and services that are to be provided; secondly, how much will I choose for the collectivity to provide; and, thirdly, once some group choice is made, how will I react to the changed market conditions that confront me? While it is essential that these three levels of choice be separated analytically, it should also be clear that the three are inherently interdependent. As in most situations of choice, “idealized” behavior requires, or seems to require, simultaneous adjustment of all the choice variables. Specifically, the individual’s choice of a tax institution will depend on his choice for a public-goods quantity and mix and upon his choice of a private market reaction to collective fiscal outcomes. Any satisfactory theory of normative behavior on the part of the individual must work out the process through which these three sets of choices are simultaneously made.
The Cost of Decision-Making
Such idealization ignores, however, one element of the decision process that can be of major importance. This is the costs of making decisions themselves. In a world where individual decisions can be made in complete isolation one from the other, this cost element may be neglected for most purposes. But in a setting where individuals must, somehow, participate in attaining some sort of consensus on collective outcomes that must, once settled, apply to all, these costs may become large indeed. Once this is recognized, even idealized individual choice need not require simultaneous determination of all values for the choice variables. In this context, it may become rational for the individual to consider his choice among rules or institutions independently from his own particular choices to be exercised within the operation of these institutions or rules. In other words, it may become rational for the individual to discuss his choice among alternative institutions under which subsequent choices will be made independently from these later choices or his predicted reactions to them.
This separation of the “constitutional” decision from what may be called the “operational” decision of the individual is important, and it is essential to the logic of Part II. It may be illustrated with reference to fiscal institutions and fiscal choice, the particular emphasis here, although it is more generally applicable. Consider the decision or choice calculus of a single reference person in a political community. He tries, we shall assume, to articulate his preferences with respect to the share of economic resources to be devoted to public rather than to private uses. He must decide on the institution of payment for public goods, the tax structure. He must decide on the quantity and mix of public goods to be supplied under this structure, the size and composition of the budget. And, finally, he must decide how he will react to the modified conditions of choice that he will confront in the marketplace as a result of the fiscal setting.
These decisions are interdependent, as noted, but when he recognizes the costs of negotiating agreements with his fellows on the institutions of payment for each and every budget, the individual may prefer, on efficiency grounds, to separate the institutional decision from the standard budgetary decision. In other words, he may agree that the group should decide, “constitutionally,” on the institutions under which fiscal (budgetary or public-goods) choices shall be made, quite independently of these choices themselves. He may say, to himself and others: “I simply do not know what public goods and services I shall want and in what quantities over a whole range of future budgetary choices, but can we not discuss the institutions under which we shall pay for
whatever public goods and services we decide to supply to ourselves, and in
whatever quantities we decide to supply them? In specific terms, can we not decide, constitutionally as it were, whether or not we shall raise public revenues through an income tax or through a sales tax?”
Such a treatment of the institutional structure in some independent “constitutional” process will reduce the costs of arriving at ordinary budgetary decisions on the quantity of public goods and services to be supplied. The imposition of such institutional constraints amounts to setting the rules of the “fiscal choice game,” whereas without such constraints the game is really without rules at all. This conclusion holds regardless of the ultimate rules for reaching collective decisions, these also being assumed to have been determined constitutionally. Whether political decisions are reached on the basis of Wicksellian unanimity, simple majority voting, or any one of the many other variants and combinations that are possible, the independent selection of fiscal institutions reduces decision-making costs. It does so because it removes from the direct budgetary calculus a whole set of bargaining counters that would otherwise be brought into play.
It should be emphasized that the incorporation of decision-making costs in the model does not necessarily imply that rational behavior requires a separation of the institutional and operational levels of choice. There seems no way of demonstrating, a priori, that either this procedure or that of simultaneous choice of all relevant variables is relatively more “efficient” in any particular circumstances. Under certain conditions, it is surely rational for the individual, and for all individuals, to choose the fiscal institutions for the supply of public goods along with this supply itself. Under certain other conditions, efficient behavior surely suggests the opposite. If this latter set of conditions are accepted as possible, then we are justified in Part II in examining the calculus through which the individual selects a fiscal institution independently of the particular characteristics of the public-goods choices that may be confronted.
Institutions as Rules
How will a member of a political community go about making a personal choice among alternative fiscal institutions? The precise setting of the problem is important, and this can perhaps best be described in terms of an explicit model.
Assume the existence of a political community in which all day-to-day decisions on the supply of public goods are to be made by simple majority voting in some town-meeting fashion. Each individual knows, in advance, that any and all proposals for fiscal action will be decided in this manner. Any citizen may present to the group motions concerning the level of public outlay on particular items, or on the levels of tax rates producing revenues for those items. Further, we assume that a given individual has no way of predicting just what proposals are likely to be presented to the group for choices, and even if he should be able to make some rough predictions in this respect, he has no way of predicting just where his own preferences would fall with regard to specific motions. In other words, the individual cannot predict whether, say next year or ten years hence, a motion will be made to spend X dollars draining the boondocks. And, even if such a motion is to be made, the individual cannot now tell whether or not he would join in support or in opposition since he knows neither his own tastes in future periods nor his own economic position.
Suppose, now, that a “constitutional” session of the group is convened, and the group is asked to decide, collectively, on an institution of taxation. That is to say, some such institution is to be selected which will, if and when approved, be used to finance
whatever expenditures that may be proposed and approved in future periods. To return to the example, the individual’s future behavior with respect to support or opposition to draining the boondocks would depend, in part, on the way such spending is to be financed. Now, however, he is asked to choose a way of financing all possible spending proposals that may be approved, independently of any knowledge of the pattern of approved motions that may emerge over time. The institution so chosen is to be imposed as a constraint, as a rule, under which particularized choices as to the content and the magnitude of public spending shall be made in a whole, indefinitely determinate, series of fiscal and accounting periods.
The selection of a fiscal institution becomes closely analogous to the choosing of rules for an ordinary game. The player does not know, at the time when he must agree with fellow players on the rules under which the game shall be played, what particular set of rules will be privately most beneficial to him in subsequent rounds of play. He cannot know this with accuracy since he cannot predict what alternatives he will face, and he cannot know the constraints under which he must operate. The inherent uncertainty in choice among rules makes consensus among separate players much more likely to be attained than might otherwise be expected. If a potential player in an ordinary card game, at the time of agreeing on the rules for play, should be able to predict the cards that he will hold in each successive round of play, he will, of course, be quite definite as to his preferred set of rules, and he will fight very hard for the adoption of this set by the whole group. However, to the extent that other prospective players are equally omniscient, agreement on a single set of rules can never be attained.
On the other hand, if no prospective player can predict his own position in the various rounds of play anticipated, consensus on rules moves within the realm of possibility. In this situation, each prospective player will be motivated to select a set of rules that will seem “efficient” or “fair” in the private or individualized sense that, whatever may be his own position, he will stand a “fair” chance of winning. The central element of conflict among prospective players that arises once individual positions are identifiable is eliminated to the extent that such identification becomes impossible.
For our purposes, the game setting becomes that of choosing among fiscal institutions. How should the individual prefer to be taxed over a whole indeterminate sequence of periods in which spendings decisions will be made by the group if he knows neither what proposals will be presented and adopted nor what his own particular preferences regarding proposals will be?
From Private Interest to “Public” Interest
Throughout this book, and in earlier works, analysis has been grounded on the choice calculus of the single individual, as a choosing unit, and he has been assumed to act so as to maximize his own utility. This is not, of course, the appropriate place to discuss the general methodological implications of this approach, but one point should be made in passing. Political scientists, and others, often refer to “the public interest” as something that exists independently of the separate personal or private interests of the individual members of a community. The approach taken here does not recognize the existence of such a “public interest,” and individuals are presumed to act simply as utility-maximizers, although utility functions need not be narrowly defined.
The approach to fiscal institutions taken in Part II allows some reconciliation of the purely individualistic and the public-interest conception of political order. If the choosing individual is placed in the position of selecting among institutions, among alternative rules of the game, and if he cannot predict with any degree of accuracy his own particular position on subsequent rounds of play, his own private interest will dictate, as suggested above, that he indicate a preference for a set of rules that seems “efficient.” That is to say, his own utility-maximizing behavior will, in this setting, lead him to choose rules that will be efficient for the group, taken as a whole. And consensus among all members on a common set of rules becomes conceptually or potentially possible. The analysis suggests, therefore, that if individuals are appropriately placed in positions where they are required to choose “constitutionally,” they can be led, by their own self-interest, to act as if they are furthering the general or public interest in some properly meaningful sense. In this setting, no conflict arises between private utility-maximizing behavior and political obligation.
This conclusion has important normative implications, some of which will be discussed more fully in a later chapter. It suggests that where possible social choices should be made under conditions where individuals find themselves in such “constitutional” situations. The utility function of the individual chooser provides different signals for behavior in such situations from those that it provides when individual positions are more readily identifiable. No explicit incorporation of interpersonal considerations need be introduced; the utility function need not be changed so as to include arguments for either the utilities or the activities of other persons. However, because the reference individual may, in any subsequent “round of play,” assume any one of many specific positions, his own utility-maximizing behavior will lead him to select institutions that are
generally efficient. And, since all members of the group may be in roughly similar situations, agreement on a
generally efficient set of rules becomes possible.
The Question of Relevance
Are fiscal institutions actually chosen under conditions that remotely resemble those postulated here? Are institutional choices made separately from day-to-day choices? Exhaustive research into the political process is not required to establish the general conclusion that the models of decision do have considerable relevance for real-world events. Nothing more than everyday observation is required to reveal that fiscal institutions are debated, discussed, and finally selected quite independently of public-goods choices. For example, the political discussion on tax reform in the United States in 1963 and 1964 was carried on largely without any consideration of the choices of spending programs that might be consequent to the reform. In part this partitioning of the fiscal decision process may well be due to fundamentally irrational or inefficient elements, and a greater allowance for the real interdependence among fiscal variables at all levels might well be highly desirable. The effects of one aspect of this partitioning have been discussed in Part I. The independent consideration of the institutional choice tends to impose constraints on ordinary budgetary choice, and, because of this, to generate inefficiency of the standard sort. If, for example, a proposal is made for a particular spending program to be financed under an existing, and presumably nonadjustable, tax structure, the required support may not be generated, despite the fact that, should some alternative tax distribution be introduced, support would be readily forthcoming.
The considerations advanced in this chapter suggest, however, that such admitted inefficiencies that stem from the independence of institutional and operational choices may be offset, at least in certain cases, by the greater efficiencies of decision-making under the fully partitioned system. A priori, it seems impossible to say that the whole fiscal choice process should not, ideally, involve a distinct conceptual separation between the institutional set of decisions and the ordinary or day-to-day operational set. The facts are that we observe such separation in almost all political jurisdictions.
A Rehabilitation of Traditional Neoclassical Public Finance?
The classical and neoclassical theory of public finance, especially as this has been developed by English-language scholars, has been criticized for its emphasis on the tax side of the fiscal account and for its relative neglect of the expenditure side. Analysis in this tradition proceeded as if taxes are exogenously imposed and as if revenues were drained out of the economy upon collection. Einaudi’s term, “imposta grandine,” which, literally translated, means “hail-storm tax,” is properly descriptive of the standard models. So-called “principles” of taxation were developed, and arguments on the basis of these continue to be presented in sophisticated discussions of taxes, without regard to the expenditure side of the budget.
This procedure amounts to an attempt to lay down “principles” for distributing the costs of public goods among individuals independently from any consideration of the demand for such goods. In the market for private goods under certain conditions, the prices that must be paid by individual purchasers are determined primarily by costs, and individual demands influence only the quantities that shall be taken. In this case, demand affects the total outlay on goods, but not the price per unit of good supplied. With public or collective goods, jointness in supply is the essential characteristic. This implies that it is impossible to provide divisible units of these goods to “purchasers” at cost-determined supply prices; individual quantity adjustment cannot take place. Cost elements can determine the supply prices confronted by the group as a unit, not those confronted by individuals. The uniformity in quantity that is made available to all individuals in the group makes necessary an apparent discrimination in “prices” charged to the various demanders, and the appropriate discrimination here can only be determined by bringing the demand side explicitly into account. The neglect of this side in deriving the so-called “principles” of taxation produces wholly arbitrary results.
I have argued in other works
*80 that the arbitrariness here is reduced to the extent that all public goods and services provide “general” rather than specific benefits. If public outlay is limited to providing only those goods and services that are made available equally to all members in the community, the neoclassical models of analysis become somewhat less one-sided than initial reflection may suggest. This is especially true if specific benefit imputations among individuals are made and accepted to be reasonably descriptive. The making of such imputations incorporates the demand side into the model, but it may do so in such a manner that allows primary concentration on the allocation of costs. If, for example, it is accepted that the marginal benefits from the enjoyment of public goods and services are roughly equal for all individuals, differences in this side of the account do not affect the distribution of tax-costs, regardless of the norms that may be accepted. In such a model, all individual demands for public goods are roughly equivalent. Hence, efficiency considerations would dictate a structure of tax-prices equal for all persons. Discussion as to “principles” for distributing taxes then becomes one of the degree to which nonefficiency norms are relevant.
A different imputation of marginal benefits may be one where these are roughly proportional to some income-wealth base. In this case, efficiency considerations alone dictate proportional income-wealth taxation, at the margin, and departures from this rule could then be discussed in terms of nonefficiency versus efficiency norms. Still other possible marginal benefit imputations might be employed, and each would, of course, yield different “ideally efficient” distributions of marginal tax-prices.
We know, however, that the traditional approach contains few attempts to justify the empirical relevance of any of the benefit imputations required to legitimatize its methodology. Secondly, we know that the public goods and services actually supplied by governments do not fully qualify as “general” in the sense indicated. For some such goods and services, benefits, both total and marginal, are
differentially made available to individuals and subgroups within the larger community. When this is recognized, the traditional neoclassical approach to tax principles seems to contain little that is worth preserving, and scientific advance seems to require that it be discarded.
This reaction, upon more careful consideration, seems premature. The institutional approach that Part II of this study opens up serves to rehabilitate, in a qualified sense, the neoclassical methodology in general terms, if not in its specific logic. At least in some circumstances, it may prove desirable and efficient for the choice among the institutions of taxation to be divorced from the choice among spending programs. The argument for such a partitioning of the fiscal decision process is based on the presumption that the institutions of taxation, which determine the distribution of the costs of providing public goods and services among members of the group, may be quasi-permanent or “constitutional” elements of the political-social structure whereas spending programs, which determine the distribution of the benefits of public goods and services among the members of the group, may be relatively impermanent or temporary phenomena. Whether or not this distinction is empirically relevant can only be determined by real-world events. But to the extent that it becomes so, we may discuss the individual’s calculus of choice among tax instruments quite apart from any specific assumptions about the spending side.
A simplified example will both clarify the setting and suggest its limitations. Assume that a political community contains only three citizens, A, B, and C. There are three possible public spending programs in each fiscal period. One of these benefits A and B equally, but provides no benefit at all to C. A second program benefits A and C equally, but provides no benefit to B. A third program benefits B and C equally, but provides no benefits to A. Assume now that each individual considers the adoption of these three programs as being equally probable in each fiscal period. Under such circumstances as these, it seems rational for any individual in the group to discuss with his fellows the introduction of a
general scheme for collecting taxes, quite independently of the particular benefit imputation anticipated in any specific period. Over time, the probability distribution of benefits to be enjoyed from various spending programs may be unknown, but this element of uncertainty itself is sufficient to make separate institutional choice rational. It must remain “inefficient,” perhaps grossly so, in some short-run or one-period sense, for the individual who enjoys no benefits at all from particular spending programs to be subjected to tax-costs equal to those imposed on his fellows, who are direct beneficiaries. But the acceptance of the institution of taxation may, in the multiperiod setting, become “efficient” in the long-run sense provided only that the individual in question expects to get his own “fair” share in the differential benefits from public services as the tax institution remains in force over a whole unpredictable sequence of spending choices.
Public Finance, XIX (February, 1964), 29-43.
The Calculus of Consent (Ann Arbor: University of Michigan Press, 1962).
Fiscal Theory and Political Economy (Chapel Hill: The University of North Carolina Press, 1960), pp. 15-17.