A short note on fiscal regimes and fiscal policy

On the political economy of taxation and spending

There is a reasonable debate about how much taxes matter. Most economists would agree that taxes do matter. However, the way in which taxes matter is often not altogether clear. More often than not when discussing taxes the tendency is to concentrate on the short-term implications of tax policy. Economists, for the most part, ignore the historical issues associated with the rise of what Joseph Alois Schumpeter, in his essay on fiscal history [1], called the Tax State, an admittedly, as he noted, a pleonastic concept. Schumpeter was concerned with the long-term implications of what might be termed a tax regime, rather than tax policy.

Looking at the way the state taxes and spends over longer periods revealed something more profound about society. He suggested that:

“… fiscal measures have created and destroyed industries, industrial forms, and industrial regions even where this was not their intent, and have in this manner contributed directly to the construction (and distortion) of the edifice of the modern economy and through it of the modern spirit. But even greater than the causal is the symptomatic significance of fiscal history. The spirit of a people, its cultural level, its social structure, the deeds its policy may prepare- all this and more is written in its fiscal history, stripped of all phrases. He who knows how to listen to its message here discerns the thunder of world history more clearly than anywhere else” (1918: 101) [2].

In this he followed Rudolf Goldscheid, the inventor of the term fiscal sociology. For Schumpeter: “Goldscheid's … the first to have laid proper stress on this way of looking at fiscal history: to have broadcast the truth that ‘the budget is the skeleton of the state stripped of all misleading ideologies’-a collection of hard, naked facts” (Ibid.: 100).

In my paper on the Tax State, influenced by Schumpeter's seminal contribution (and the work of Richard Musgrave,[3] who I met at a conference at the New School in 1997, and suggested the work by Schumpeter) I discussed the broad issues associated with the power to tax and the political decisions about how to spend resources in what might be seen as part of the old and forgotten classical political economy tradition. My concerns with fiscal history were to some extent related to the problems in developing countries, and were based on the notion that government spending had been a key engine of economic growth [4]. However, the discussion of the tax state, and of the reasons for the decline of the welfare state, that was part of that work, led me to the question of fiscal regimes.

Fiscal Regimes and fiscal policy

Historians have paid significantly more attention to the question of taxation, and the rise of the fiscal state. Perhaps the work of John Brewer, and the notion of a Fiscal-Military State is central in this context, in particular his The Sinews of Power: War and the English State, 1688–1783. This has led to a rich comparative literature on the rise of the fiscal state, mostly about the European experience [5], and to further discussion by the authors of the New Fiscal Sociology.

In this context, taxes are often seen as an obligation without a direct counterpart. As some authors in this tradition explain:

“What is new about the new fiscal sociology is its recognition that taxation has a theoretical or causal – and not just a symptomatic or methodological – importance. This stems from the definition of taxation itself. Taxation consists of the obligation to contribute money or goods to the state in exchange for nothing in particular. To be sure, taxes are sometimes earmarked for particular uses, and in modern, democratic societies, taxation carries the implicit promise that the resources will be spent on public goods … a tax is not a fee paid in direct exchange for a service, but rather an obligation to contribute that the state imposes on its citizens and, if necessary, enforces” (Martin et al., 2009: 3) [6].

The kind of power necessary for the imposition of taxes, and the social conflicts that may emerge when consent is not easily granted, are central to understand the intricate histories of the emergence of fiscal states. Perhaps, that is why the notion of tax regimes appear in this literature rather than in economics.

Campbell (2005: 392) defines tax regimes as “… a combination of taxes and tax rates that policy makers adjust in order to achieve their policy goals” [7]. We can extend this to the spending part, and think of fiscal regimes as combinations of taxes and tax rates, as well as public spending programs that can be graduated, within the same regime, to achieve broad societal goals. In other words, a fiscal regime is a framework of rules and policies that govern how and from whom revenues are obtained and utilized. It is about the specific policy tools used to raise funds, what types of taxes are levied, and on what groups, and at what level, and for what specific purposes.

Fiscal regimes tend to be established and to endure for relative long periods of time, and are often only abandoned in periods of crisis, or distress that require the development of a new fiscal regime. Fiscal policy, on the other hand, is much narrower, often associated with specific use of government spending and taxation to influence the economy in the short-run.

For example, the American tax regime inaugurated with the constitution in 1787, and designed by Alexander Hamilton, imposed tariffs to fund debt service, a standing army and a small bureaucracy. The tariffs at the beginning were relatively low, to avoid retaliation, and the bounties (subsidies), provided for industrial development, non-existent. The fiscal regime remained in place until the Civil War in the 1860s, but tax policy did change several times, with tariffs being increased in 1816, ironically with great support of Jeffersonians, that supposedly were for free trade. After 1828 tariffs were gradually reduced, and remained relatively low up to the war. In other words, tax policy might change without affecting the overall tax regime [8].

The historian W. Elliot Brownlee provides, in his Federal Taxation in America, a detailed description of the evolution of the fiscal regimes in the United States. The post-bellum fiscal regime was based on much higher tariffs, something that Donald Trump would like to emulate, and generous transfers of public land to local governments and relatively cheap land for infrastructure development. A brief income tax was also implemented during the Civil War, but permanently established in 1913, only after the Supreme Court had deemed it unconstitutional, and an amendment was passed to allow for it. The income tax became central after World War I, even if Republicans reduced the tax rates temporarily in the 1920s.

It was only with the New Deal that the modern Welfare State – somewhat incomplete in the US would come to be, and it would not only expand a series of social programs, complemented in the 1960s during the Kennedy and Johnson administrations, but impose a whole new series of payroll taxes – that a new fiscal regime emerged. It is that fiscal regime that has been severely weakened since the Tax Revolt of the 1970s, that I discussed in my paper on the Tax State.

Why fiscal regimes matter?

In the late 19^th century, views about inequality and poverty went through a significant change, with the punitive views of the Poor Laws, after the 1834 reform, and the workhouses left behind. The Social Gospel, the rise of socialist ideas, and the increasing organization of the working class in trade unions were important elements of those changes. But, in the United States, the progressive era policies were limited at best. It was only with the New Deal that a significant expansion of what would be called the Welfare State occurred. Anwar Shaikh suggested that the Welfare State was fundamentally financed by taxes on the working class, and that in a sense workers paid for the welfare that they received [9]. In the case of the United States that is very clear. The expansion of social welfare programs went hand in hand with the expansion of payroll taxes.

This seems to suggest that, while it is true that for the most part taxes result from spending and do not necessarily, in a macroeconomic perspective, finance it, without a well establish tax regime, in which the ability to raise, on a persistent basis, revenue, certain types of expenditure are not politically feasible [10]. It should not be a surprise that the United States, with a tax revenue as a share of GDP at the low end of the range for advanced economies, is the only one without a national healthcare policy, for example. In other words, fiscal or tax regimes might limit, or at least make it more difficult in political terms, to develop a certain set of social policies.

In other words, what is politically feasible for an administration to do in terms of fiscal policy, might be better understood within the confines of a fiscal regime. In that sense, the tax regime matters. That does not necessarily mean that in order to expand spending the government has to raise funds beforehand, and that is not just in the short-term context of fiscal policy measures. It might be the case that the creation of a new type of social benefit, leads to increasing political support for a new fiscal regime that creates new sources of revenue. But it is clear that Social Security in the United States would not have passed without increasing the burden of taxation on the working class [11]. The social compromise that allowed for that, and other momentous changes to take place, would have been impossible without the Great Depression, a crisis that threatened the very foundations of the capitalist system.

Changes in fiscal regimes often happen at times of crises, perhaps the 2008-9 crisis, that saw the rise of populist protests in the United States, and led to the Obama presidency, and the expansion of the public health system, was a missed opportunity for a new fiscal regime. It is unlikely that Trump’s belated and regressive changes in the tax system, with an attempt to return to the pre-World-War I tax regime, would have a persistent effect on the fiscal regime.

Notes:

[1] I often suggest that this is the best, or even the only relevant, contribution by Schumpeter to economics. See Schumpeter, J. (1918), “The Crisis of the Tax State,” in R. Swedberg (ed.), Joseph A. Schumpeter: The Economics and Sociology of Capitalism, Princeton: Princeton University Press, 1991.

[2] This quote was the epigraph of the book I edited on fiscal issues, and the need to its rediscovery, something that only happened after the 2008-9 Global Financial Crisis, titled after Keynes’ famous pamphlet were the ideas of the General Theory were first published. See P. Berglund and M. Vernengo (eds.), The Means to Prosperity: Fiscal Policy Reconsidered, London: Routledge, 2006.

[3] His essay on the subject is an important exception among mainstream economists. See Musgrave, R. (1980), “Theories of Fiscal Crisis: An Essay in Fiscal Sociology,” in H. Aaron and M. Boskin (eds.), The Economics of Taxation, Brookings: Washington, DC. See also Vernengo, M. (2004), “Political Economy and the Tax State: The Power of the Purse in Historical Perspective,” in S. Durlabhji (ed.), Power in Focus, Hiram, GA: Wyndham Press.

[4] In this view, which might be termed classical-Keynesian, or Sraffian, growth is ultimately demand driven, not supply constrained, and following the logic of the principle of effective demand, taxes are seen as the result of autonomous spending, which generates income, and determines the level of activity of the economy. This is the same idea that has been associated with the notion of functional finance, as developed by Abba Lerner and more recently by Modern Money Theory authors. It is important to note that, in most countries, were the central bank cannot directly fund the Treasury, and directly buy government bonds, then it is the case that the government may use its tax revenues, deposited in the central bank, to fund spending. The argument is developed in Lavoie, M. (2013), “The Monetary and Fiscal Nexus of Neo-Chartalism: A Friendly Critique,” Journal of Economic Issues, 47(1): 1–32.

[5] See the collection of papers in Bonney, R. (ed.) (1999), The Rise of the Fiscal State in Europe c.1200–1815, Cambridge: Cambridge University Press.

[6] See Martin, I., Mehrotra, A. and Prasad, M. (2009), “The Thunder of History: The Origins and Development of the New Fiscal Sociology,” in I. Martin, A. Mehrotra, and M. Prasad (eds.), The New Fiscal Sociology: Taxation in Comparative and Historical Perspective, Cambridge: Cambridge University Press.

[7] See Campbell, J. (2005), “Fiscal Sociology in an Age of Globalization: Comparing Tax Regimes in Advanced Capitalist Countries,” in V. Nee and R. Swedberg (eds.), The Economic Sociology of Capitalism, Princeton: Princeton University Press.

[8] For a discussion of tariff policy, that explains the fundamental changes in this period see Irwin, D. (2004) “The Aftermath of Hamilton’s ‘Report on Manufactures’,” Journal of Economic History, 64(3): 800-821.

[9] See Shaikh, A. (2003), “Who Pays for the ‘Welfare’ in the Welfare State? A Multicountry Study,” Social Research, 70(2): 531-550.

[10] In developing countries there are further limitations on the ability of governments to spend, associated with the need to import essential intermediary and capital goods, and with the possible existence, as a result, of an external constraint. Some of these arguments are discussed in Vernengo, M. and Pérez Caldentey, E. (2020), “Modern Money Theory (MMT) in the Tropics: Functional Finance in Developing Countries,” Challenge, 63(6): 332–348.

[11] The short-term effect was actually to, in part, bring about the so-called Roosevelt Recession of 1937-38, that increased taxes at the same time that Roosevelt, who was essentially for austerity, and his fiscally conservative Treasury Secretary tried to balance the budget and reduce spending. See Vernengo, M. (2009), “A Hands-off Central Banker? Marriner S. Eccles and the Federal Reserve, 1934-51,” in R. Leeson (ed.), American Power and Policy, New York: Palgrave-Macmillan.