Adam Smith's Principles of Taxation in the Early American Republic

Frank Garmon Jr.1

Compared to Smith’s thoughts on trade, banking, and the market process, his views on taxation have been comparatively understudied. As Deborah Boucoyannis noted recently, “With only a few exceptions, Smith’s system of taxation has not been assessed as a whole” (Boucoyannis 2013, 1058). This chapter examines the logic behind Adam Smith’s principles of taxation and their application in the early American republic. It argues that early- American policy makers applied theories proposed by Smith and others because these fiscal strategies proved less distortional to the market process than other forms of taxation. Although it was Adam Smith who best distilled these maxims, the reasoning underpinning Smith’s theories circulated widely among eighteenth-century political thinkers. While much of the literature has emphasized fiscal policy enacted by the new federal government, federal taxation existed concurrently with taxes collected by state governments. State governments levied the most visible and important taxes that taxpayers would have encountered in the early republic. Legislators in the early republic developed a unique system of taxation by centralizing the collection of indirect taxes in the form of the federal tariff, and simultaneously decentralizing direct taxes through federal apportionment and state tax collection. By studying state and federal taxes as part of a comprehensive system, this chapter examines how the founding generation both empowered and constrained the taxing powers of government.

The system of state and federal taxation that emerged out of the struggles under the Articles of Confederation shaped the development of early- American tax collection. Geoffrey Brennan and James Buchanan have demonstrated that tax systems take on semi-constitutional qualities by establishing the rules that guide individual and state actors. Tax systems establish a set of rights, a mechanism for enforcement, and a set of rules governing collective decisions. Consistent rules provide clear expectations for both taxpayers and public officials. Brennan and Buchanan argue that stable tax regimes amount to a form of social capital that is susceptible to destruction by altering the rules of the game (Brennan and Buchanan 2000). After an initial period of experimentation, tax collection in the early republic remained consistent for approximately fifty years, until several states began rewriting their state constitutions in the second quarter of the nineteenth century. The federal Constitution both empowered and constrained federal taxing authority by coupling unlimited indirect taxing powers with an imperfect system of direct taxation. State governments yielded their authority to levy taxes on imports under the Constitution in exchange for a preservation of their fiscal autonomy in the sphere of direct taxation. The combined federal and state system placed constitutional limits on taxation and divided taxing authority in a way that sought to minimize distortions in the market process (Hayek [1960] 2000; Buchanan 2000a, 2000b).

The framers of the Constitution hesitated to provide the federal government with unlimited taxing authority, believing instead that federalism would promote responsible government and that divided authority would prevent abuse. Political scientists studying fiscal federalism and economists following public choice theory have also stressed the importance of decentralized authority in a federal system. Fiscal federalists argue that when voters’ preferences are geographically dispersed, local officials are best informed to make decisions on behalf of their constituents (Oates 1972). Public choice economists make a similar case for decentralization, arguing that decentralized government provides a check against wasteful expenditures by forcing self-interested state actors to compete for revenues (Brennan and Buchanan 1980). In the case of the early republic, decentralized tax collection reduced administration costs because state governments subcontracted the assessment and collection process to local officials at a fraction of the cost. Through applying the principles of Adam Smith and others, state governments implemented fiscal strategies that facilitated economic growth. The methods of tax collection formalized in the early republic allowed state governments to collect significant tax revenues while minimizing the burden of taxation on the average taxpayer. Although the early federal government would have appeared hidden from view to the average American, the combined state and federal system wielded significant taxing authority and fiscal capacity.

The first section of this chapter outlines Adam Smith’s principles of taxation and investigates their relationship with other political theorists in the late eighteenth century. Although Smith provided the clearest explication of his tax theories, iterations of his proposals circulated widely in the half century following the publication of Wealth of Nations. The second half of the chapter examines Smith’s reception in the early American republic. The founding generation read Smith avidly and incorporated elements of his maxims into their tax systems when they installed new tax administrations after the American Revolution. The combined system of federal and state taxation owes almost as much to Adam Smith’s principles as it does to Alexander Hamilton, who read Smith closely and proposed a grand vision for concurrent tax powers. Hamilton articulated the benefits of Constitutional limitations on taxing authority in The Federalist Papers. The Constitution constrained the federal government’s power to levy direct taxes but provided it with unlimited authority over indirect taxes. The combined federal and state system of taxation had the effect minimizing distortions in the market process by limiting the burden of taxation on average Americans. The chapter concludes by briefly exploring Smith’s legacy in American tax policy.