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
Existing Institutions and Change
The Effects of Time in Fiscal Decisions
“An Old Tax Is a Good Tax”
To this point the familiar taxes have been discussed only under certain highly restricted assumptions. Only
new taxes designed to finance public services not currently supplied have been considered. This chapter is devoted to an examination of this single feature of taxation. How does the fact that a tax is new or old affect individual behavior in collective choice processes, and, through this behavior, ultimate group decisions? The importance of this feature has been widely recognized in both popular and scholarly discussion, at least indirectly, and is summarized in the adage: “an old tax is a good tax.” To what extent and in terms of what criteria does this adage hold?
The descriptive words “old” and “new” must first be clarified. Under the rubric “new tax,” as used in preceding chapters, fiscal choices were assumed to embody the imposition of some tax not previously in existence to finance public-goods supply. This constraint does not require that the institution of the tax be new. An incremental addition to an existing rate of tax qualifies as a “new tax,” so long as it is imposed for the financing of new services, although these, also, may represent incremental additions to existing services. The relevant requirement is that the funds for financing newly available units of public goods and services be drawn from the financing of private goods and services. The collective decision, and the individual’s participation in this decision, must reflect a diversion of resources into public-goods supply.
This situation may be contrasted with that which is present when public goods and services are financed from revenues produced from an existing tax, an “old tax.” Most orthodox fiscal analysis assumes, implicitly, that choices are made, carte blanche, presumably at the beginning of each fiscal period. Under this assumption, the group determines both the means of financing and the range and quantity of public goods and services at the outset of each period. The slate is wiped clean, so to speak, at the end of each period, and everything is commenced all over again at the start of the following period. In such a model, there is no distinction to be made between an old and a new tax.
A more realistic analysis must incorporate some recognition of the old tax-new tax distinction, and it must be based on the acceptance of fiscal institutions, as institutions. An “old tax” is one that has been approved in past periods for the financing of public goods, and one that may be, if desired, continued in existence. The initial legislative act need not, although it normally does, include more than a single fiscal period for the life of the tax. What is required, instead, is that a new diversion of resources be involved in changing the existing situation, including change to the pretax state. In other words, if the
status quo, defined with respect to income and product flows in time, is to be maintained, the pattern of financing-spending, public and private, that exists in period t
0 will be repeated in period t
1, other things equal.
Suppose that a community in period t
0 imposes a new tax to finance a newly available collective or public good. As compared with the situation that exists in period t
-1, the decision to supply the public good diverts resources from private-goods supply to public-goods supply. Those persons who participate in the decision process, the voters-taxpayers-beneficiaries, are more or less consciously aware of the real “cost” of the newly produced public goods, this awareness being subject to the problems of estimation that have been previously discussed under the separate taxes. Compare this consciousness, given any particular tax, with that which will be present in the situation confronting the individual member of the community at the beginning of the period t
1, when the relevant choice concerns the possible continuation of the taxing-spending process. Here a decision to supply the same amount of public goods again in t
1 and to finance this with the old or existing tax schedule does not involve a positive imposition of real costs on individuals in a temporally differential sense. As compared with the situation in t
0, existing fiscal institutions may be continued in being without any person in the group undergoing change in his economic position. In objectively measurable units, the public goods that are supplied cost the same in sacrificed private goods in the two situations. Subjectively, however, as this cost affects individual choices, and through these, group decisions, the opportunity cost of goods financed through the old tax may be substantially lower than those for the same goods financed through the levy of a new tax, given the same tax institution.
The phenomenon discussed here is not, of course, unique to fiscal choices. Any departure from a position of “dynamic equilibrium” will require a somewhat greater impulse than a continuation of the pattern of flows that have been established.
*15 In the most general terms, the appropriate analogue is the physical law of inertia. It is easier to continue a flow once started than it is to start it in the first place. All that is necessary for this point to be accepted as relevant for an individual decision calculus is some acknowledgement of a temporal sequence of choices.
The analysis here concentrates on fiscal choice. As suggested, the opportunity costs that are relevant for individual choice are necessarily subjective, and these costs cannot be measured independently of choice itself. These costs exist in the mind of the individual choice-maker only at the moment of decision.
*16 In any new tax situation, these opportunity costs, which serve as the obstacle to positive choice for the individual, consist in the anticipated sacrifice of future enjoyments from resources employed in the same manner as they are
currently employed. The psychic income that must be sacrificed in choosing to provide new public goods is visible, apparent, to the individual who chooses. He must reduce his consumption of private goods in order to secure the benefits of the additional public goods that the tax levy is expected to finance. By contrast, in an old-tax, or existing-tax situation, these opportunity costs, although objectively identical, appear different to the individual who chooses. Here they consist in the expected enjoyment from employing resources for private purchases that are not now being purchased. The potential employment of additional resources in private markets, and not the sacrifice of existing or current enjoyments, is the opportunity cost of public goods in the old-tax case. There is, necessarily, a less evident connection between a decision to finance public goods and the costs of this choice than there is in the new-tax situation. The costs under the old tax are, to repeat, units of psychic income which are not being enjoyed currently in the same form, and which may, conceptually, come into being only if the tax is not continued.
If the analysis is correct here, there exists a threshold of response between positive choice under one institution and under the other,
ceteris paribus. Hence, at the margin, the demand for public goods under a new tax must exceed that under the old tax if the same quantity is observed to be provided. That is to say, other things equal, the individual will tend to “vote for” a somewhat larger public expenditure under an old-tax financing scheme than he will under new-tax financing. In terms of the simple diagrams that were introduced in Chapter 2, this threshold phenomenon can be represented by a displacement of effective tax-price downward in the case of an old- or existing-tax institution.
The behavioral difference here is not, of course, unique to fiscal decision processes, and it need not arise from irrationality and illusion on the part of the participant. The behavioral difference is consistent with rationality in individual choice provided only that the costs of decision-making are incorporated in the analytical model. The making of decisions, the choosing among alternatives either in private or collective choice situations, is costly to the individual who participates. He must invest time and resources in securing information about the alternatives available for choice and in evaluating and analyzing this information, or else he must bear the additional costs that are involved in the greater probability of error, costs that must also be attributed to the decision process. Once these decision costs are recognized, it is clear that the repetition of a choice, over periods subsequent to the initial one in which a definite decision is made, involves considerably lower cost than the making of a decision to
change. In the limit, the repetition or continuation of choice in later periods,
ceteris paribus, can be evaluated at zero marginal cost; no new investment in information gathering, in evaluation, need be made unless some of the parameters of the situation should have been modified. The minimization of decision cost through time will always imply the routinization of activity, the continuation of existing rules and institutions, the repetition of past behavior, the rejection of new alternatives. Some “wedge,” some threshold, will be inserted between the selection of an existing alternative and the selection of a new one.
In the traditional approach to public finance, the adage “an old tax is a good tax” is satisfactorily descriptive, provided that the criterion of “goodness” is the minimization of “burden” on the taxpayer. In this approach, public expenditure decisions are exogenously made, or at least made independently of tax decisions. The old tax is here less burdensome to the taxpayer than the new tax for the reasons mentioned. The adage is also useful as a rule for “government,” considered to be divorced from the individuals in the jurisdiction. The old tax generates less reaction than the new tax; more funds can be raised by adherence to this rule. In this particular application, therefore, the underlying political models yield similar results. Expenditures from old-tax revenues need not satisfy such rigorous standards of “efficiency” as those financed from newly imposed taxes. This fact is, of course, widely recognized by politicians and pressure groups who support public spending programs. The primary difficulty encountered is that of securing approval of a program
initially, in “getting over,” so to speak, of the first decision to approve.
*17 Appropriations in subsequent time periods are never so difficult to secure.
Experience suggests that, almost universally, tax and public spending rates which are increased, temporarily, to meet wartime or other emergency fiscal needs remain substantially higher in postwar, post-emergency periods than before. One explanation that has been advanced for this result, by Alan Peacock and Jack Wiseman, involves the so-called “displacement effect.”
*18 The emergency modifies the tolerable limit of taxation that the community will accept. This explanation is closely related to, and dependent upon, some recognition of the old tax-new tax differential discussed. The two explanations can be readily translated into the same hypothesis. Wartime spending needs are such that the threshold of decision can be crossed with newly imposed taxes or with substantial increases in rate levels of existing taxes. The additional real costs, in opportunity-cost terms, of the expanded spending program are accepted in the emergency setting. Once these needs disappear, however, the bias is shifted in favor of a continued high level of public activity, as opposed to a return to some pre-emergency balance between the public and the private sector. Not having to undergo the apparent sacrifice of real resources generated by new-tax financing, the individual is more willing, in post-emergency periods, to approve spending on the provision of services than he should have been in the pre-emergency fiscal setting. A corollary hypothesis is, of course, that the longer the emergency, the more pronounced this effect will be; that is to say, the older the tax, the more routine the institution, the greater the likelihood that it will be continued in existence.
The institutional influence examined here may have important implications for national policy in the late 1960’s and early 1970’s. Concern has often been expressed about the potential reaction of the public, and its political leaders, in the event that genuine agreement on disarmament should allow for drastic reductions in military or defense expenditure by the federal government. The stabilization impact of substantial reductions in outlay, accompanied by corresponding tax reductions, might indeed be serious, given the rigidities that characterize the institutions of monetary authority. The analysis here suggests, however, the federal spending programs, considered over-all, would not be dramatically reduced, especially after the continuation of such a long period of high-level cold war spending. Effective disarmament would immediately produce vigorous pressures to expand federal nonmilitary spending programs, and barriers to such programs in terms of additional taxes would no longer be present. The limited cuts in military outlays during the early years of the Johnson administration accompanied by the substantially increased outlays on domestic programs tend to confirm this hypothesis. The extension of the “welfare state” becomes much more predictable in the event of effective disarmament.
Revenue Elasticity and Fiscal Choice
A more important implication, and one that has been widely recognized, at least indirectly, in recent years, concerns the effects on public spending that follow from a tax structure which provides automatically for relatively increased revenues as aggregate income rises. Almost all real-world tax institutions of significance involve income as a base, directly or indirectly, and hence must satisfy this requirement to a degree. The effects are most dramatic, however, in those cases where the elasticity of revenue yield exceeds the income elasticity of demand for established spending programs. For example, suppose that a public spending program in operation can be maintained, over a period when national income increases, by increases in dollar outlay only one-half so large, proportionally, as the increases in income. On the other hand, suppose that the tax institution originally earmarked to finance this public service program will yield revenues, at existing rates, that increase proportionally twice as fast as national income. This combination of circumstances will bias collective fiscal decisions, relatively speaking, in favor of new spending programs. Proposals for new public outlay will be much more likely to secure favorable political response than would be the case under the requirement for new-tax financing. Hence, quite apart from income-elasticity considerations, equivalent programs for public spending will secure more taxpayer support during periods of rising national income than they will during periods of stable national income, provided only that the rate structure of taxes is such that revenues are highly income elastic. This conclusion is also evident to politicians and pressure-group leaders, as witness the fiscal experience in the United States in the 1950’s and 1960’s. The fiscal choice analysis here serves to place familiar and obvious institutional experience in a consistent theoretical setting.
Tax institutions vary significantly in income elasticity of revenue. For this reason, some distinction among the major revenue-raising categories must be made. In a period of rapidly increasing national product, that tax institution characterized by the highest elasticity will tend, other things equal, to generate the largest volume of public spending. Under this consideration, the progressive income tax, the corporate income tax, and the excise tax on specific consumption items of high income elasticity are the revenue sources to be singled out. The personal income tax, because of the progression in its rate structure, generates revenue increases in response to income changes that are more than proportional to the latter. This tax will, therefore, tend to produce more favorable public attitudes toward expanded spending programs than will most comparable fiscal institutions, other things equal, when national income grows. This conclusion cannot, however, be pushed too far, since it must be kept in mind that this tax remains direct, and, therefore, its impact is sensed to a greater degree by the taxpayer than the less direct taxes. By comparison to a proportional income tax, the progressive tax surely has the effect of making expanded spending programs more acceptable politically. The tax on corporate income must also be noted especially in this connection. Not only are its revenues highly sensitive to aggregate income changes due to the residual characteristics of corporate profits; the tax is also indirect in its effect on the individual fiscal calculus.
The institutional biases outlined here are, of course, reversible. If national income should decline, the revenue flexibility of a tax becomes an element that makes the enactment of new spending programs, or even the maintenance of existing programs, more difficult, provided only that the rules of the fiscal game require some matching of revenues with expenditures. If, in the case of a national government with money-creating powers, the balanced-budget rule is not directly observed, this reversibility may not be effective. During periods of falling national income, public spending may be maintained, or even expanded, without the imposition of newly enacted taxes or increases in rates of existing taxes. We shall discuss the whole area of “functional finance” and its implications for individual fiscal choice in a later chapter.
Multiperiod Choice and Tax Capitalization
In our initial analytical models, the tax to be levied was assumed to be a
new tax, a restriction that we have discussed above, but also the fiscal choice examined was limited to the
current period of time, on both the tax and the benefit side. That is to say, we have assumed implicitly up to this point that the public goods or services provided are enjoyed only in the current period and that the tax employed to finance these services is imposed period by period, whether this be a new tax or an old one in the sense discussed above. The reason for this current-period restriction is evident: the fiscal choice situation confronted by the individual in the one-period setting is considerably less complex than that which he faces if he benefits and/or the costs should be known to extend over a sequence of time periods.
Consider now a multiperiod model, while remaining within our standard reference system of the individual as voter-taxpayer-beneficiary; that is, as the ultimate chooser in the democratic political process. What modifications must be introduced in the analysis of choice behavior as a result of this change in the setting? The most obvious one arises from the necessity to translate benefits and costs that are expected to occur in future periods into present-value units. A discounting or capitalizing process becomes an essential element in the individual’s decision calculus, and one that is wholly absent from single-period models. Insofar as this process itself embodies additional uncertainty, the making of decisions becomes more difficult, more costly, to the individual.
Other distortions arise that are closely related to the old tax-new tax distinction already examined. If the time pattern of both benefits and taxes is known with precision, the discounting process can be applied straightforwardly to both sides of the account, and no directional bias need be introduced. If, however, the exact dating for future taxes and for future benefits is not carried out, or if this procedure is either impossible or implausible because of the nature of the fiscal institutions involved, the capitalization may not be uniformly applied to the two sides. Suppose that a proposal is made to impose a tax on the capital value of residential real property in a community for the purpose of financing a program of vocational education. (We neglect intergroup distributional considerations here.) We want to look at the behavior of the owner of residential real property, the potential taxpayer, who is, at the same time, a potential beneficiary of the public services of the program. How will he choose the preferred rate of tax along with the desired quantity of public service? In the current-period models the problem is conceptually simple, relatively speaking. And, even in a multiperiod model, if both time shapes are precisely predictable, little need be added to our previous discussion. For example, if the tax is limited to five years, which is also the designated life of the spending program, and, further, if a uniform quantity of services is to be financed each year, then the discounting process is not tedious, and it need not distort fiscal choice. Let us suppose, however, that the legislation proposed is “open ended” in time, so to speak. That is to say, both the tax and the spending program are to remain in effect indefinitely. Here the complications that are introduced into the individual’s decision calculus become significant. To the degree that the tax is specialized to a particular characteristic of the individual economy, and to the degree that it is expected to remain in being over time, capitalization will occur. The owner of the property subject to tax will experience a once-and-for-all decrement in its capital value at the moment the tax becomes effective. The “burden” of the tax, over time, is concentrated in this initial period to the extent that capitalization occurs. A similar process will take place on the spending side. Prospective beneficiaries recognize that the program currently initiated will be continued. Hence, they should experience or “sense” a windfall gain at the time or the moment of effective social decision, a gain that represents some capitalized value of an expected benefits stream.
In the example here, however, it seems likely that the individual who is both taxpayer and beneficiary will tend to capitalize the tax obligation more fully than he will the offsetting benefit stream. If he does so, some distortion is introduced into the subjective evaluation of the alternatives that he confronts. The reason for this predicted difference in his treatment of the two sides of the account is found in the differential marketability of the asset taxed and the benefits enjoyed. In the example, the object of the tax is residential real property. This property is assigned to individual owners, and each parcel carries with it a current market value. The owner may dispose of a parcel, at its market value, at any time of his own choosing. The tax acts to reduce this capital or market value to the extent that it is capitalized. On the other hand, the benefits stream, although enjoyed by the individual in common with others, and valued by him, does not provide a privately marketable asset that allows him to secure liquid funds at his discretion. Hence, despite the fact that, in the net, the two sides may discount to the same objectively measurable present value, the individual will tend to overvalue the tax or cost side. He will consider his liquidity to be reduced by the tax, but not to be increased to an offsetting extent by the benefit stream that is anticipated. For this reason, in the example, the individual’s fiscal choice tends to be biased against supporting the proposal for levying the tax and financing the program of spending on vocational education. There will be an institutional bias here against spending on long-term-benefit projects. The bias or distortion here is caused by the difference in generality between the tax and the benefit side. As suggested, tax capitalization will occur to the extent that the tax is specific, and this phenomenon has been traditionally discussed in application to asset taxes. On the other hand, in the example, benefits are assumed to be generally available to all members of the group, indivisible and unassignable into separate shares. When the asymmetry runs in this direction, fiscal decisions are likely to exhibit institutional bias against spending on long-term projects yielding general benefits.
If, however, the asymmetry should be reversed, an opposing bias would appear, as a second and different example can make clear. Suppose that the tax to be imposed is a general one, say, a proportional tax on income, while the spending program involves specific and assignable benefits to owners of property, say, free water for irrigation purposes. In this model the expected benefits should be immediately capitalized into the value of the land, whereas the tax will not tend to be capitalized to any comparable extent. Accordingly, as citizen-taxpayer-farmer, the individual will be quite favorably disposed toward the initiation of long-term projects financed under such arrangements. There will be an institutional bias toward public spending under these arrangements.
The point may be further emphasized by examining specifically the situation of an individual, in each of the two examples above, who plans to leave the local community after a period of, say, three years following the period of the initial fiscal decision. In the first model, he will find that the capital value of his property which he must sell has been adjusted downward for the expected tax obligation, whereas he cannot, to the same extent, “sell” the capitalized value of the expected benefits stream to a prospective buyer of his land. He could do the latter only if he could, in some fashion, sell his “membership” in the community. Recognizing that at the time of the initial decision, the individual who thinks that he might move from the community will, of course, place more weight on the tax side than the benefit side in making fiscal choices. By contrast, the individual in the second example, where benefits are more specific than the tax, will find that he can sell his property at a capital value that has been adjusted upward to incorporate the expected benefits from the irrigation water. On the other hand, a comparable adjustment in assets value downward to reflect the tax may not have taken place.
These illustrative examples should not be allowed to make the point seem more important than it is. To some extent, any local government fiscal action is specific, and, to this extent, some capitalization will occur. If the only means of entering a local community is to become an owner of real property, then both taxes and benefits will be capitalized. The implications developed are relevant, however, for the more realistic situations where non-property owners are allowed to participate in fiscal choices along with property holders. The analysis here obviously yields several hypotheses that can be subjected to empirical tests.
The institutional distortions that may be introduced in multiperiod fiscal choice by unbalanced capitalization applies only to the initial decision concerning whether or not to approve or disapprove a taxing-spending proposal. Other important institutional influences may arise when changes in existing programs are proposed. These are fully analogous to the old tax-new tax factors previously discussed.
Suppose that the community imposes the tax on residential real property to finance the program of vocational education, our first example above, but that no cut-off date for the program is included in the authorizing legislation. Let us also suppose, at the time of the initial decision, the objectively measured present value for the benefits stream exceeded that for the tax costs. However, let us now suppose that one or two periods have passed, and that it has become clear that the initial expectations of benefits were in error and that actual benefits are much lower than had been anticipated. Objectively considered, the program should be curtailed and the tax law repealed. However, if the tax has been effectively capitalized, by the owners of all assets subject to tax, the opportunity costs of continuing the program will “appear” to be low indeed. The “real” costs will, of course, consist in the possible windfalls that would occur in the moment of repeal. But this element of opportunity cost does not seem likely to exert such an influence on fiscal choice as it might do in some omniscient pattern of behavior. To fail to take a decision on repeal of a tax embodies an opportunity cost that, properly measured, should be no different from that embodied in the initial enactment of a tax. But the individual does not “sense” the two opportunity costs as identical, dollar for dollar, or even approximately so. The institution of tax capitalization seems, therefore, to bias fiscal decisions toward the continuation of spending projects once these are initiated, despite the fact that during the initial consideration the bias may run in the opposing direction. This conclusion applies, of course, only to the first sort of model, in which the tax is more specific than the benefit. In the converse model, where the benefits are more specific than the tax, relatively greater capitalization of benefits takes place, and more effective opposition will arise in each period to any continuation of tax levies in existence. In this case, if spending projects turn out to be grossly inefficient, they will probably be curtailed more readily due to individual pressures on the politicians.
The basic hypotheses concerning individual behavior in fiscal choice situations that have been advanced in this chapter should be subjected to empirical testing insofar as this proves possible. The hypotheses are more general, however, and there are many commonly recognized versions, despite the fact that they have perhaps not been fully incorporated into the standard body of economic theory. The classical economists discussed the notion of interest as a payment for “waiting,” which Nassau Senior changed to “abstinence.” There is a difference, psychologically, between the meanings of these two terms, and this difference is the one emphasized in the hypotheses of this chapter. “Waiting” implies the cost of setting aside current income, current consumption, for capital formation. “Abstinence” implies this also, but, in addition, the cost of refraining from “eating up” capital already accumulated. Logically, of course, to put aside current consumption is identical with refraining from consuming invested capital, that is, from converting it into current consumption. But individuals do not behave as if “eating up” capital is identical with refraining from accumulating it in the first place. And their behavior is not necessarily irrational, for the reasons that we have examined in this chapter. The opportunity costs of holding capital are fully analogous to those of continuing a long-existing tax or one that has been substantially capitalized; these costs consist in potentially enjoyable alternatives that are not
currently in flow to the individual. Psychologically, these costs do not serve to inhibit individual decision to the same degree as do comparable measured costs in units of
currently enjoyed flows of services. If uncertainty is not positively valued by the individual, this reaction is individually rational, quite apart from the costs of decision itself. Hamlet said that it is better to bear those ills we have than to fly to others that we know not of, but his statement applies also to benefits or pleasures. A decision to initiate action involves the giving up of known benefits in exchange for necessarily uncertain alternatives. A decision to continue a course of action once initiated becomes just the reverse; continuation becomes the
status quo, and the uncertainty elements arise on the cessation of established flows through time.
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