Post-War Tax Policy

Post-War Tax PolicyAuthor(s): Benjamin HigginsSource: The Canadian Journal of Economics and Political Science / Revue canadienned'Economique et de Science politique, Vol. 9, No. 4 (Nov., 1943), pp. 532-556Published by: Wiley on behalf of Canadian Economics AssociationStable URL: http://www.jstor.org/stable/137438 .

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POST-WAR TAX POLICY*

(PART II)

pREVIOUS post-war experience is so uniform, and economists differ so little in their prognoses for the next post-war period, that it seems

safe to be somewhat dogmatic about the situation that post-war tax

policy must meet. In the absence of measures specifically designed to

prevent it, there is every reason to expect the typical post-war pattern of hesitation, inflation, deflation, boom, and prolonged depression.' It is clear that the unprecedented magnitude of the war effort could lead to fluctuations of unprecedented violence. If the Japanese war were to end soon after the European war, or if it were on a much smaller scale, it is conceivable that the uncertainty characteristic of the months just after cessation of hostilities might lead directly to deep depression. During the reconversion period, there is bound to be serious unemployment in certain industries and regions, that could start a cumulative downswing if allowed to produce a commensurate drop in national income. If on the other hand the Japanese campaign lasts several months and is on a comparable but nevertheless smaller scale, the "hesitation" period may be completely ironed out.

In the first year or two after the European armistice, and perhaps even for a similar period after the Japanese armistice, the primary economic problem will still be scarcity of consumers' goods relative to

potential demand for them. The money supply has already risen over 70 per cent since war began, and with $1.75 billion of war bonds in the hands of individuals and another $1.5 billion in the hands of non-financial

*Part I, dealing with tax policy for control of monopoly, appeared in the August, 1943, issue of this Journal. Part II is concerned with tax policy for control of income and employment.

Two errata appeared in Part I. On page 414, line 7, "(AC - R)" should read "(AC + R)," and in line 25, "where (AC - R) is" should read "where (AC + R) is."

'For a brief summary of post-war business cycles, see H. G. Moulton and K. T. Schlotterbeck, Collapse or Boom at the End of the War (Brookings Institution, 1942). On the general nature of war and post-war cycles, see W. C. Mitchell, Wartime Pros- perity and the Future (Occasional Paper no. 9, National Bureau of Economic Research, New York, 1943). British and American experience after the last war is outlined in Economic Fluctuations in the United States and the United Kingdom, 1918-22 (League of Nations, 1942). A somewhat more detailed account of the American post-war inflation and deflation is presented by Wilson F. Payne, Business Behaviour, 19I9-22 (Chicago, 1942). See also Thomas Wilson, Fluctuations in Income and Employment (London, 1942). The Canadian post-war cycle is analysed by the author in a memorandum presented to the Advisory Committee on Reconstruction under the title, "The War and Post-war Cycle in Canada, 1913-23."

532



Post-war Tax Policy

corporations even before the fifth war loan, it could rise another 70 per cent through sale of government securities to the banking system if war ended tomorrow.2 Refundable taxes are still another source of monetary expansion. Moreover, much of the increase in bank deposits now consists of idle business reserves that may be activated after the war, leading to a rise in velocity of circulation as well. A doubling of monetary demand in the year following the war is by no means inconceivable. Since the supply of final products cannot be quickly increased, a sudden doubling of the price level is perfectly possible. Once under way, such an inflation has no foreseeable limits. Since the inflation problem seems likely to be with us for some time to come, we have accorded it more space in this paper than the long-run problem of under-employment.

When hostilities cease, some reduction of total government outlays is both possible and desirable, as labour and resources become available for re-converting war-time plant and equipment to peace-time production. Dr. Leonard Marsh has estimated that an expenditure of $2 billion on social security and public work will be necessary to maintain national income in the first post-war year, a smaller amount as it becomes safe to unleash consumer purchasing power. Adopting this figure, we would have total government outlays of about $2.5 billion including ordinary expenditures. If the war ends soon, net national income at market prices will be running at about $10 billion per year, total government expenditures at about $5 billion and total tax collections at about $2.5 billion. Thus reduction of government outlays to $2.5 billion in the year after hostilities cease, when little or no increase in consumer spending will be possible without inflation, will require increased private investment of some $2.5 billion if national income is to be maintained.

The task of tax policy in the immediate post-war period will be to stimulate the required increase in private investment while at the same time preventing inflation. The task will not be easy. Total investment in war plant and equipment is not much over $1 billion, and net new investment during the entire decade of the 'twenties, including residential housing, was less than $5 billion.3 There can be little doubt that it would be easier to maintain national income if public expenditures were reduced by less than $2.5 billion. However, it must be admitted that the current

2The financial effects of Canada's war effort are presented in some detail in my essay, Canada's Financial System at War (National Bureau of Economic Research, 1943).

3Official figures of war investment were published in the Financial Post, April 24, 1943. Figures of net new investment from 1920 to 1930 are presented in the Report of the Royal Commission on Dominion-Provincial Relations (3 vols., Ottawa, 1940), vol. I, p. 116.

533



534 The Canadian Journal of Economics and Political Science

tendency for national debt to concentrate in the hands of financial institutions, other business concerns, and individuals in the middle and upper income groups creates ethical and economic problems that make it worthwhile to limit further additions to debt as much as possible.4 Dr. Somers has shown that the size of deficit required to produce a given national income varies with the manner in which revenues are obtained.- For the sake of analysis, we shall assume that there is some tax system that will induce the required increase in private investment; our problem is to find it.

In one respect, the immediate post-war situation is less happy for the policy-maker than war or depression. In war, any policy discouraging either consumption or non-essential private investment is good; in depression, any policy encouraging either consumption or private investment is desirable. Just after the war, however, it will be necessary to stimulate investment while still discouraging consumption.

As reconversion is completed, tax policy must be gradually altered so as to encourage both consumption and investment. Indeed, unless unforeseen outlets for private investment appear, it will probably be wise for long-run tax policy to concentrate upon raising the propensity to consume.

THE "FUNDAMENTAL EQUATIONS"

Post-war tax policy, then, should aim at increasing investment while restricting consumption immediately after the war, and shift gradually to encouragement of consumption as additional consumers' goods become available. To facilitate analysis, we shall set up some simple "stream" equations. In these equations, we shall use "saving" and "investment" in the "Robertsonian" sense: investment is current expenditure on capital goods, saving is "yesterday's" income produced and earned less "today's" outlays on consumption, a "day" being any income-period in "clock time."6 "Consumption" is synonymous with "consumer spending."

4f the tax system were "neutral" with respect to debt distribution, so that every- one's tax payments were just offset by interest received on government obligations, the last argument against unlimited increases in national debt would disappear. Un- fortunately, other considerations may prevent the use of such a tax system.

5Harold M. Somers, "The Impact of Fiscal Policy on National Income" (this Journal, Aug., 1942, pp. 364-85).

6Since such prominent "Keynesians" as Professor Hicks and Mr. Kaldor have now confessed their liking for the Robertsonian definitions, it is perhaps no longer necessary to apologize for using them in preference to the Keynesian definitions (J. R. Hicks, "The Monetary Theory of D. H. Robertson," Economica, Feb., 1942, and N. Kaldor, "A Model of the Trade Cycle," Economic Journal, March, 1940). However, it might



Post-war Taxm Policy

We shall assume that taxes paid out of today's disposable income (yesterday's earned income) are assessed on yesterday's earned income. Even when taxes are collected on a "pay as you earn" basis, this assumption is still the realistic one, since in nearly all cases taxes are deducted at the end of the income-period from income earned during the period. The reduction in disposable income through taxation is felt in the income-period following that in which the income is earned. De- noting private investment by I, savings by S, consumption by C, government expenditure by E, tax collections by T, and national income by Y, and indicating time-periods by subscripts, we have

Y1 = C + I + E1; C = Yo- (S + T1) and YF - ~Yo = (I1- S1) + (E1 - Ti) ...... (1)

If I is interpreted as net investment, then Y becomes net national income at market prices, and if I is interpreted as gross investment, then Y becomes gross national product. Unless otherwise stated, we shall define I as net investment.

We shall divide income recipients into two classes: "capitalists" who

be worth mentioning that in matters of tax policy the "Keynesian" definitions become inconvenient, since the discontinuity of income payments and lags between government outlays and tax collections become particularly important.

Dr. Kalecki has approached the problem of tax policy in depression through "stream" equations of the Keynesian sort ("The General Theory of Commodity, Income, and Capital Taxation," Economic Journal, Sept., 1937). His general conclusion was that "capital taxation is perhaps the best way to stimulate business and reduce unemployment." Fundamentally, his argument is that since a capital tax does not enter into prime cost or reduce the return to investment, a tax on all assets including cash balances will not discourage investment, while expenditure of the proceeds will encourage it. However, he throws up a fearsome barricade of assumptions to get his results, and his conclusions are less secure when the barricade is removed. His final conclusion would apply equally to a tax on hoarding. Perhaps most important, his failure to take account of lags between collection and expenditure of government revenue impairs the usefulness of his analysis.

Carsten Welinder uses a period analysis quite similar to the one presented here ("Grundziige einer dynamische Inzidenztheorie," Weltwirtschaftliches Archiv, Jan., 1940). There are, however, other limitations in his analysis. First, for some strange reason, he neglects the effects on investment of government expenditure. Second, he fails to show the importance of the form of government expenditure, particularly whether the proceeds enter directly into profits or go first into wages. Third, the possibility that expenditure may precede collection of the tax even with the budget balanced over the fiscal year is not considered. Fourth, the lag between collection and expenditure receives insufficient attention. Fifth, his definition of profits is an accounting rather than an income concept, and it is questionable whether profits in his sense determine entrepreneurial decisions in all cases. His use of "general elasticity of demand" to mean the total effect on consumption of a change in taxes is confusing, and his restate- ment of principles in terms of this "elasticity" is tautological and redundant.

535




own all fixed plant and equipment, including land, and "workers" who perform all services. National income consists of "wages" and "profits." Any individual may, of course, be both worker and capitalist. Workers as such do no saving; anyone who saves becomes to that extent a

capitalist. Thus if "profits" or total returns to assets are denoted by R,

Y1 = R1 + Wt and R1 - Ro = (Y1 - W1)- (Yo - Wo) = (Y - Yo) + (W - W1)

= (I - S) + (E1 - T1) + (Wo - W1) ......(2)

Obviously, if the wages bill is constant, R - Ro = (II- S) + (E1- Ti) ......(2a)

The capitalists will be concerned primarily with profits net of taxes, which we shall denote by R'. We should then have

R' - R, = (1 - S) + (E1 - T1) + (Wo - W1) + (T - T) ......(3)

We shall assume that in the absence of concrete factors that would create expectations of a change in trend, investment decisions are based

upon the trend of profits net of taxes. That is,

I2 f (R -R) ......(4)

Finally, we are interested in the price level of consumers' goods. If P is the average price level of final products, G is the quantity of such

goods, and v their velocity of circulation per "day," then Po = Co/Gvo. In the immediate post-war period, on the assumption that the supply of consumers' goods remains constant for that period, we would have

P2 - P1 = C2 C/Gv = [Y - (S2 + T2)] - [Yo - (Si + T1)]/Gv = (I - S) + (El - Ti) + (S1 - S2) + (TF - T2)/Gv = (r + E1) - (S2 + T2)/Gv. ..... (5)7

We can now state our "prognosis" in terms of these equations. As-

suming that the war ends soon and that capital is just maintained in the last "day" of war, we would then have, in billions and in terms of annual rates,

Y1 = II + C +$E1 = $0 + $5 + $5 $10

We also assume that national income is constant in the last "day" of war, which is a reasonably realistic assumption if the price ceiling holds. Then, Y- Yo = (I, - S1) + (El - Ti) = ($0 - $2.5) + ($5 - $2.5) = 0

Now the war ends, and the government cuts its outlays in half. If in-

7This equation illustrates the cumulative nature of inflation. Any uncompensated rise in Pi over Po will lead to a rise in profits over "day 1" and so to increased investment in "day 2," which again raises prices in "day 3," and so forth.



Post-war Tax Policy

come is to be kept constant, private investment must increase by $2.5 billion, giving us

Y2-Y1 = (12 - S2) + (E2 - T2) = ($2.5 - $2.5) + ($2.5 - $2.5) = 0

and Y2 = I2 + C2 +E2 = $2.5 + $5 + $2.5 = $10 In this equation, we have a stable system with a balanced budget. How- ever, there will be strong pressure on any government in power to reduce taxes. Suppose taxes are also cut in half, leaving a deficit of $1.25 billion. Then Y2 - Y1 = ($2.5 - $2.5) + ($2.5 - $1.75) = $11.75. That is, inflation takes place. Suppose investment increases only $1.25 billion, despite a reduction of tax collections by 50 per cent and expenditures of $2.5 billion. Then Y2 - Y = ($1.75 - $2.5) + ($2.5 - $1.75) and income is apparently stable. The appearance is illusory, since unless consumption rises, Y2 = I2 + C2 + E2 = $1.75 + $5 + $2.5 = $8.75. That is, if reducing taxes results in an increase in investment of only $1.25 billion, either saving increases and income falls, or consumption increases and inflation results. Our first important conclusion, therefore, is that any deficiency in private investment must be made up by public spending rather than by tax reductions, unless tax reductions result in no increase in consumption and the windfall resulting from tax reduction goes entirely into new investment.

It is quite possible that the government in power when war ends will find it politically inexpedient to maintain existing tax rates. If no means of reducing taxes can be found without increasing consumption and thus causing inflation, tax reduction must be accompanied by stringent rationing and intensive loan campaigns in order to increase savings. For example, stability might be achieved with

Y2 = I2 + C2 + E2 = $2.5 + $5 + $2.5, and with

Y2 - Y1 = (I2 - S2) + (E2 T2) = ($2.5 - $3.25) + ($2.5 + $1.25). It is worth reiterating that if tax reduction fails to call forth sufficient private investment to keep national income stable, it may be necessary to maintain government expenditure above the level of $2.5 billion per year. For example, we might have stability with

Y2- Y, = ($1.25 - $3.25) + ($3.25 - $1.25).

Finally, it must be remembered that to the extent that additional consumers' goods become available in the first post-war year, increased consumption is permissible. We are primarily concerned, however, with the period in which such increases are still dangerous.

It is clear from equation (1) that tax policy may operate either through the creation of deficits or surpluses, or through influencing

537




consumption or investment while maintaining a balanced budget. There is nothing in the equation to tell us whether deficits created by increased government expenditures or by reduced taxes would be more effective in raising the level of national income; that is, in our particular setting, whether the maintenance of national income could be accomplished with a smaller deficit through relatively high expenditures and taxation or through relatively low expenditures and taxation. With business psy- chology as it is, it seems likely that almost any reduction in taxation would be more stimulating to private investment than almost any form of public expenditure, but this "hunch" cannot be established as fact by economic analysis. Tax reductions have the advantage of leaving the

government with more freedom as to future policy than do public work

expenditures, since outlays for public work in one "day" commit the

government to future outlays for operation, maintenance, and repair. Tax reductions also leave more freedom as to how national income shall be spent, but this argument is largely offset by the fact that public spending usually benefits the lower income groups more than does tax reduction.

Equation (1) also shows that if the budget were balanced at every point of time, tax policy could operate only through its influence on

private consumption and investment; that is, it could operate only by redistributing income. It follows that any tax policy can be entirely offset by an expenditure policy that returns income to exactly the same

people as pay the taxes and in exactly the same amount. In order to isolate the effects of tax policy by itself, it is necessary to assume that the budget is balanced at least within a limited period, and that public expenditures take some definite form. In what follows, we shall assume that public expenditures consist of outlays on public work and social

security, and that the lag between changes in taxation and in expenditure is only one "day."

EFFECTS OF TEMPORARY DEFICITS

No matter what the tax structure, lasting effects upon the level of national income may result even when a cut in tax collections (or ex-

penditures) is offset by an equal change in expenditures (or tax col-

lections) in the next "day." When the war ends, expenditures may be cut before taxes, or taxes may be cut before expenditures. There are historical examples for both procedures.8 We shall consider both very

8Speaking generally, after the last war expenditures were cut before taxes in Eng- land, and taxes were cut before expenditures in Canada and in the United States. In the six months after the Armistice, government deficits decreased in Britain and increased in Canada and the United States.



Post-war Tax Policy

briefly, beginning with the case where tax reductions come first. The ultimate results depend upon reactions of capitalists to the "impact effects" of tax reduction.

Case I

Suppose that in an "equilibrated" economy with a government deficit just equal to excess savings, taxes falling primarily upon the incomes of capitalists (corporate income, excess profits, and inheritance taxes) are reduced. Suppose further that when the tax reductions are announced, the government declares its intention to demobilize the army, and that "capitalists" accordingly anticipate a drop in labour income equal to the drop in tax payments. Two sub-cases can be distinguished: (a) where the "capitalists," because they anticipate a decline in their incomes due to reduced purchasing power of "workers" (armed forces), do not spend the windfall profits accruing from tax reduction; and (b) where they spend their windfall profits in the first "day" and make any necessary savings in the second "day" when their incomes are smaller.

Case I (a)

Day 1: S - So = TI - To = T - T (by assumption); Io + Eo = SI + T; [ - (I - Si)] = (E1 - T). Thus Y1 = Yo (equation 1) and R1 = Ro (equation 2) and Pi = Po (equation 5). But R' - R' = T- T' (equation 3).

Day 2: Savings now revert to their original level. S2 = So; 12 - I > 1 (4); T2 - T, also > 1, but if taxes are < 100 per cent on

profits, [ - (12 - S2) > (E2 - T2). Thus Y2 > Y1 (1). Moreover, outlays on "wages" fall; (E2 - E1) = (W2 - W1) by assumption, R -R = (Y2- Y1) + (W1 - W2) + (T - T2), which is positive, unless tax rate is 100 per cent.

Day S: The rise in profits in Day 2 leads to increased investment in

Day 3 (4). However, unless workers are in a position to dishoard

consumption falls by (W1 - W2). Moreover, owing to the rise in profits in "Day 2," tax collections in Day 3 will be higher. Accordingly, unless

capitalists increase their total spending by more than (W1- W2), [ - (13- S3) > (E3 - T3) and income falls (1); and since T' > Tj,

net profits (3) and prices (5) also fall. In other words, unless the armed forces are able to maintain consumption by dishoarding, which is highly unlikely, or unless capitalists borrow or dishoard an amount that exceeds the profits of "Day 2" by the extent of the rise in taxes in "Day 3," a cumulative downswing may start in "Day 3." As profits fall, tax collections will also fall; but unless the government is willing to increase its

539




deficit, expenditures drop by a like amount, and if this policy is anticipated by capitalists, reduced tax collections need not damp the downswing.

Case I (b)

Day 1: In this case, the windfall profit resulting from reduced taxation is spent in the first day-let us suppose that it is invested, so that no inflation takes place. Then [- (Ii - S1)] < (E1 - T1) and Y- Yo = To - T(1),9 and R' - R (Yi - Yo) + (T; -T) (3).

Day 2. The rise in profits in "Day 1" leads to no further increase in investment, since it is known to be temporary. Moreover, capitalists now save to offset the drop in their incomes due to reduced government expenditure in the previous "Day," and capitalists pay higher taxes owing to the rise in profits in the previous "Day." Consequently, [ - (2 - 2) ] > (E2 - T2) and a downswing may start at once. If,

however, savings rise only by T' - T2, then although - (12 - S2) ] > (E2 - T2) and so Y2 < Yi (1), there is no immediate

fall in net profits, since T2 is still substantially less than To, and (W1 - W2) = (T' - Ti). If capitalists anticipate a rise in government expenditures equal to the rise in tax collections over "Day 1," the downswing may conceivably be postponed.

Day 3: Consumption now falls by (W1 - W2). Even if profits were maintained in the previous period by dishoarding of capitalists equal to (T2 - T[), income, profits, and prices will fall unless capitalists borrow or dishoard still further. Since the only favourable factor in "Day 3" is the rise in government expenditures that has already been anticipated, there is no reason for capitalists to go on sustaining the economy by their own investment. Unless the government declares its intention to increase expenditures by the amount of its previous cut in expenditures, there is no prospect of maintaining profits. Thus the final result is the same under (b) as under (a).

Using the same sort of technique, it can be demonstrated that if the reduction in expenditures hits profits directly-say through cancellation of contracts for war materials already in production-the results are the same, except that there is no initial rise in profits in either the first or second days, and accordingly the downswing starts earlier and from a lower level of activity. When expenditures entering labour income are reduced, there is more chance of induced investment offsetting the decline in consumption in the third day than if expenditures entering profits are cut. Thus if capitalists anticipate the reduction in expendi-

9Since Si = Yo - (C1 + T1), and C1 = Co, S1 - So = To - T1 = I -- Jo. . Y - Yo = To - T1, and not, as might seem at first glance, (To - T1) + (Ii - Io).



Post-war Tax Policy

tures, we are forced to the unpleasant conclusion that it is better to reduce expenditures entering into labour income than expenditures entering directly into profits.

Case II

Let us now deal very briefly with the case in which the reduction in expenditures is not anticipated, and the whole of windfall profits is spent in the same day that reduced tax collections are announced. As before, we shall first assume that the expenditures chosen for reduction consist of pay to the armed forces.

Day 1: (I1 - Si) + (E1 - Ti) = T' - T = Y1 - Yo =R1-Ro, all positive. R' - R = (R1 - Ro) + (To - T'), and therefore (R[ - Ro) > (R1 - Ro). If the whole of windfall profits are invested, P1 = Po. If the whole of windfall profits are consumed, P1 - Po =To - T/Gv.

Day 2: Taxes rise somewhat, due to the previous rise in profits, but probably not so much as (12 - Il). In any case, (W1 - W2) = (Io - Il). Thus net profits rise again (3).

Day 3: In this period, consumption falls by W, - W2, and taxes rise. Unless private investment rises enough to offset both the rise in taxes and the fall in consumption, income, prices, and profits will fall and a downswing will start. The corresponding fall in taxes will under conditions postulated for this case damp the downswing, giving us a con- verging series.

If the cut in expenditures comes directly out of profits, it is felt by entrepreneurs in the second "day" instead of in the third, profits fall in the second day, and the downswing starts earlier and from a lower level. Investment must rise enough in the second day to offset both the fall in government expenditures and the rise in taxes if income and profits are to be maintained.

Thus it makes little difference whether the reduction in expenditure is anticipated or not, except that there may be a greater tendency for the downswing to be "damped" by accompanying tax reductions if the consequent reductions in expenditures are not anticipated. However, we have seen that the chances of avoiding the downswing are greater when expenditures entering into wages are reduced rather than expenditures entering directly into profits, simply because the reduction is felt by capitalists one day later and accordingly "leverage" has one more day in which to operate.'?

l?Symmetrical results are obtained for tax increases. A rise in taxation followed by an equivalent rise in expenditures, whether or not anticipated, may lead to an upswing, and is more likely to do so if the increase in expenditures is felt by entrepreneurs in

541




If taxes on investment, such as property taxes, are reduced, the chances of an "upswing" (stable income with reduced deficit) are improved on two scores. First, the value of capital goods, which is the sum of yields net of taxes over the life of the asset discounted by the relevant rate of interest, will rise relative to their cost of production. Second, since secondary rises in taxes occur one day later than when taxes are imposed directly on "profits," the "leverage" effects of the initial rise in investment and reduction in taxes operates over a longer period before offsetting tax increases are felt, and the chances of overcoming the effects of reduced public expenditures are greater.

When reductions in taxes falling on consumption are substituted for reductions in taxes falling on profits in these model sequences, there is surprisingly little difference in effects on national income. The reason is simply that both C and I are part of Y and a rise in either C or I will in itself tend to raise net profits. The equations by themselves do not tell us anything about "incidence" of various taxes and consequent re- distribution of income. Such differences as appear are due to different

secondary effects on tax collections themselves. Increases in consumption due to lower consumption taxes bring windfall profits in the same period, and if A C/A R is less than unity, the secondary rise in taxes is less if we are concerned with taxes on consumption than it is if we are concerned with taxes on profits. However, it is not a matter of indiffer- ence whether the maintenance of national income with reduced deficits is due to increased consumption or increased investment in the immediate

post-war period; for the former case implies inflation, and the latter reconversion of plant for peace-time production. In terms of the analysis in this section, reduction of taxes on consumption would be inappropriate.

Case III

For the sake of completeness, we must consider briefly the case where

expenditures are cut before taxes. As before, we shall assume that lower

government outlays result from demobilizing the armed forces. A subse-

quent cut in taxes is announced at the same time, and fully anticipated by "capitalists." We can distinguish two sub-cases: (a) where "capitalists" increase their investment in anticipation of lower taxes, and (b) where they do not because they also anticipate less consumer spending.

the second day than in the third. When the increase in expenditure is not foreseen and accordingly capitalists do not maintain their outlays in the first day by borrowing or dishoarding, an initial downswing starts, but a reverse tendency sets in when the expenditures are felt.



Post-war Tax Policy

Case III (a)

Day : I1-Io = Eo-E1; (I-Si) + (E -Ti) =0; Yi = Yo; P1 - Po. But R' - R; = Wo - W. (If capitalists increase consumption as well as investment, prices will rise.)

Day 2: Investment increases over its former level (4). T- T Wo - W1 = Cl- C2.. Y2 - Y1 I - I = R-R. Thus an "upswing" develops, permitting reduced deficits. If, however, any of the increased net profits spill over into consumption before additional consumers' goods are available, inflation will result, or "workers" real income will fall.

Case III (b)

Day l: Eo - Ei Wo - W; T'o = T; [-(I - S) ] > (E - Ti) ; Y1 < Yo (1), but P1 = Po (5) and R' = R (3).

Day 2: C- C2 = Wo- W1 = To - T; S1- S2 =(YO - Y1)- (C - C2).

If - C/A = 1, S2 = S1; E = E1; (T- T) = (Eo-E1). Thus if I2 = II, as we would expect from (4), (Y2 - Y1) = (T - T2)

andR - R = (Y2 - Y) + (T - T2). Therefore an "upswing" develops. If- A C/A Y < 1, S2 < S1,

incomes and profits rise even more, and the "upswing" will be still more pronounced-that is, deficits can be cut still more quickly without reducing national income.

Case IV

Let us now consider the case where government outlays entering into "profits" are reduced-say by cancellation of war contracts-and reduced taxes on profits are anticipated.

Day 1: [-(11 - S)] > (E - T1); Yo - Y1 = Eo-E1 =R -Ri. Day 2: Suppose investment is sustained despite the drop in profits,

because reduced taxes are anticipated. I2 = I1; E2 = T2; but (T2- TJ) < 1; since C2 = C1 and (Y1 - Yo) < 1, (S2 - Si) < 1, and [(I2 -S2) + (E2 - T2)] > 1; .. Y2 - Yi > 1 (1) and R2 - R > 1 (3).

If savings drop by (Yo - Y1) - (T' - T), then Y2 = Yo. This case is an interesting but a puzzling one. Profits have risen over the

previous "day," but are just the same as in the original "day" ("day zero"). Thus investment may increase in the third "day," leading to an "upswing," or equilibrium may be re-established with the same deficit as in day "zero." Similarly, if (S - S2) < [(Y - Y) - (T' - T2)], net profits will be above "day 1" but below "day zero"; "capitalists"

543




may be gloomy or hopeful, and either an "upswing" or a "downswing" may develop.

We have by no means exhausted the possible "models," and we have neglected secondary effects on the propensity to consume, liquidity preference, and other refinements. The chief virtue of this section is its reiteration of the extreme delicacy of tax policy in a situation where inflation and depression are simultaneously to be feared, and its demon- stration that failure to synchronize reductions in tax collections and government outlays might have serious consequences even if the required reductions have been correctly estimated. For the little they are worth, the concrete conclusions are that if deficits are to be kept constant, after the initial cut to offset spontaneous increases in investment at war's end, it is better to reduce taxes on profits than taxes on consumption, to cut outlays entering into "wages" rather than outlays entering into "profits," and to cut expenditures before taxes if "capitalists" believe that the

government will carry out its promises. However, there is no economic sanction for constant deficits if they

require so "regressive" a fiscal policy, and the real lesson of this section is that the administrative branch of the government should have power to vary deficits as it sees fit. Expenditures are more flexible than taxes and easier to direct into the required channels; the government should provide a budget for public work and social security to meet any con- tingency, with no requirement that the whole amount must be spent in any given period.

SELECTIVE TAX REDUCTIONS

In this section, we shall consider the efficacy of reducing various kinds of taxes in stimulating increased investment just after the war, and increased consumption later as additional consumers' goods reach the market. Even with present tax structures, we can expect some increase in private investment as restrictions on use of men and resources are removed, and as war production declines and men are released from the armed forces. The task of tax policy in the immediate post-war period is to maximize the increase in investment, while keeping con-

sumption constant, thus minimizing deficits required for a constant national income. Such a tax policy probably requires an improved prospect for net profits. It is important, however, that capitalists' con-

sumption should not be increased, and it is also important that no decline in total consumption take place. It is particularly desirable that there be no decline in workers' real income as a consequence of fiscal

policy. In other words, tax policy should aim at producing the following pattern:



Post-war Tax Policy

Day 1:

R'-R = (11 - S1) + (E1 - T) + (Wo - W1) + (T- TI) WO = W7; (I - Io) = [(Eo -To) -(E1- T) ] ..P = Po, and YF = Yo; but R- RI = To - Ti.

Day 2: 12 - Ii = RI-Ro = El - E2; P2 = Pi; W2' = W1, since increased private investment offsets reduced public spending.

Day "N": As additional consumers' goods appear on the market, (En-1 - En) = [(Cn - Cn-1) + (In - In-1) ]. As (In - In-1) approaches zero, (En---E,) approaches (Cn - Cn_l) = (W, - Wn-1) and Rn approaches "standard" profits, which we might denote as R's.

Excess Profits Taxes. Having introduced as one of our final objectives the reduction of net profits to some "standard" rate that is considered adequate and equitable, it might be well to begin our discussion with the role of excess profits taxes in producing the desired level of investment or consumption. In Part I, we introduced an excess profits tax scheme designed to eliminate excess capacity in existing plant and to reduce net profits to some "standard" rate.1l It is our opinion that the excess profits tax should be reserved for these two functions, and shouldnot be used to stimulate new investment, through reductions in rates. We have proposed that profits on bonafide new investment should be exempt from excess profits taxation for a limited period, so as not to discourage "venture capital"; beyond that concession, however, excess profits taxation should be retained as a control factor.

Payroll Taxes. Reduction of payroll taxes would fit reasonably well into the "ideal" pattern. While there is considerable doubt as to the precise incidence of payroll taxes, it seems safe to say that it will not fall entirely upon "workers" except in cases where a monopolistic trade union is faced with a competitive market for labour.12 This fact is enough for our purposes. There is, however, one complicating factor. If payroll taxes are reduced, unless relative bargaining power of "workers" and "capitalists" is changed by the tax reduction, wage rates will tend to rise.13 The increase in wage bill paid by "capitalists" we shall call W', and taxes paid by "workers" we shall call T". In order to prevent both deflation and inflation, we must have

(Eo - E1) = (W-- Wo) + (T7 - T) = (I, - Io) + (To - T1). It is clear that this balance is a highly delicate one. If it is achieved,

subsequent developments will conform to the "ideal" pattern. For

"This Journal, Aug., 1943, pp. 425-7. 12The incidence of payroll taxes is analysed in J. Dunlop and B. H. Higgins, "Bar-

gaining Power and Market Structures" (Journal of Political Economy, Feb., 1942, pp. 23-4).

131bid.

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under these conditions, (R -Ro) = (T - T) - (W[ - Wo), which is positive. Accordingly, investment will rise again in "Day 2." Payroll taxes will rise with the increase in private employment, tending to "damp" the upswing. When the '/gestation period" for the new investment is over, excess profits taxes can be applied to the new enterprise, and deficits can be reduced accordingly.

Unless there is need to check an incipient inflationary boom, there is no economic justification for building up a "reserve" for future benefit payments. Therefore, as additional consumers' goods reach the market, payroll taxes may be reduced again to stimulate greater consumption. If it is desired to prevent any increase in investment resulting expressly from reduced payroll taxes, exemption from excess profits taxes may be revoked except for new enterprises that are considered useful in the long run, and which would have been developed in any case. "Capitalists" would then tend to spend [(T7 - Tn1) - (W - W'n-) ] on consumption, in addition to previous consumption outlays. "Workers" would tend to increase their consumption by [(Tn - Tn'- ) + (Wn~ - Wn-) ]. Thus the whole tax reduction would tend to go into increased consumer spending, permitting a reduction in government spending equal to the drop in tax revenues.

At the present time, total payroll tax collections in Canada are hardly large enough to serve as a device for manipulating the flow of investment and consumption. They cannot be expected to play a major role in Canadian post-war tax policy; but as the scale of our social security programme grows, payroll taxes may become a very effective instrument for fiscal control.4

Sates Taxes. Except for H. G. Brown, who contends that a manufacturers' sales tax is partly absorbed by the manufacturer and partly shifted backwards to workers and producers of raw materials,15 recent writers seem to agree that a sales tax tends to raise prices. The direction of shifting depends very largely upon market structures and the relative

14Since the tenor of my argument must already have suggested to the reader that in my mind "tax policy" and "expenditure policy" are really inseparable, a word specifically on expenditure policy may be permitted. As we saw in Part I, a subsidy paid to employers equal to marginal wages bill minus marginal productivity of labour for any desired level of employment in any industry would tend to induce employers to hire the desired number of workers in each industry. Selective subsidies of this sort would serve not only to maintain the level of employment and income, but also to allocate labour in an approved manner. There is, therefore, something to be said for such selective subsidies in preference to general unemployment benefits when depression threatens.

15H. G. Brown, "The Incidence of a General Output or a General Sales Tax" (Journal of Political Economy, April, 1939) and "Correction" (ibid., June, 1939).



Post-war Tax Policy

bargaining power of the manufacturer in the labour, raw materials, and retail markets. In the immediate post-war period, however, it seems most likely that the "soft spot" in the hierarchy of markets will be the market for final products. That is, in equation (3) the imposition of the tax would result in neither a fall in W nor a fall in R', but an increase in C through a rise in prices.

Since a general sales tax, even if confined to manufacturers, cannot be "shifted" in the ordinary sense in which the term is used in partial equilibrium analysis, a word of explanation is perhaps necessary. First of all, the rise in prices might be accomplished with a constant stream of purchasing power by restriction of output. With the pressure of consumer demand that will exist in the transition period, this possibility can be ruled out. Secondly, the capitalists themselves may provide the increased purchasing power for the rise in prices by borrowing more from the banks, perhaps on the basis of the rise in inventory values. Thirdly, consumers may simply accept the rise in prices and diminish their savings accordingly.

It does not follow, however, that a reduction in sales tax will of ne- cessity have exactly the reverse effect. A reduction of prices through increased sales of final products is ruled out by assumption for the immediate post-war period. It seems unlikely that manufacturers would voluntarily reduce prices so long as demand exceeded supply at current prices. Nor is it likely that a reduction in sales taxes would be regarded as justification for a rise in wages even by trade unions. Thus reduced sales taxes would in the first instance constitute a windfall to entrepreneurs, and would tend to stimulate increased investment in the following day.

In successive "days," the analysis would follow the pattern of Case I, with one difference. In case a rise of prices occurred in any day, the secondary effect would be a rise in sales taxes. This rise would in itself tend to be passed directly on to the consumer in higher prices, and the lower the tax the less are the chances of a cumulative price inflation. The possibility of reducing the deficit is not a clear-cut gain when its only effect is'to prevent a price rise without increasing either consumption or investment. There is some basis, therefore, for supporting a reduction in sales tax in our analytical framework. It has the added advantage that when additional consumers' goods become available, the lower sales tax would then tend to reduce the price at which they were sold, and so shift some of the total tax burden away from the lower income groups. Moreover, it would have a good effect upon morale even in the immediate post-armistice period when no actual

547




increase in consumption was possible. Once reconversion is completed, the case for lower sales taxes is unequivocal.

In the case of partial sales taxes, such as excises on tobacco and liquor, amusement taxes, etc. the proper policy would be to reduce taxes on those items for the production of which there exists excess capacity. The only exceptions would be where the demand is highly inelastic, so that reduced taxes would lead only to increased outlays on other commodities where excess capacity was not available, or where the demand curve is actually upward sloping. If, for example, there were excess capacity in the brewing industry but reduced taxes on beer would result in less beer drinking and more whisky drinking, such a reduction would be undesirable unless excess capacity also existed in the distilleries. It seems likely that on this criterion taxes on cinema tickets and nightclub bills could be reduced-which is another way of saying that they should not have been raised during the war.

Income Taxes. When income tax rates are as high as they are in Canada, they fall on wages as well as profits. In the first "day," when income taxes are reduced, income and profits rise unless the entire reduction is offset by increased savings. Under our present tax structure, such an offset requires that a fall in government expenditures is anticipated by both entrepreneurs and workers in proportion to their contri- bution to the tax, and that they accordingly do not spend any of the tax reduction. If workers anticipate a fall in wage-creating expenditures which is less than the reduction in their share of the tax, their consumption will increase; if entrepreneurs anticipate an accompanying fall in

profit-generating expenditures in excess of the reduction in their share of the tax, but also anticipate increased consumer spending, their investment need not diminish. The result would then be a rise in incomes, profits, and prices in the first "day." In the second "day," taxes will rise somewhat while expenditures will fall, but the reduced budget deficit may be offset by increased investment. If consumers expect the rise in tax to lead to a smaller increase in wage-generating expenditures, they may save to offset it. To avoid a fall in income, the rise in investment must cover both the rise in tax and the fall in consumption. In any case, the initial rise in prices is undesirable and even dangerous; a further rise in prices can be avoided only by a rise in taxes and savings relative to expenditure and investment that would produce a downturn which may lead to cumulative deflation (equations 1 and 5).

The answer seems to be that "workers" should be convinced that the tax reduction will lead to an equivalent decline in wage-generating expenditures and persuaded not to increase their consumption, but to save their "windfall gains" to maintain consumption in the following



Post-war Tax Policy

"day." Profits would then rise in the first day, leading to increased investment in the second day which would probably offset the secondary rise in tax collections, leaving income relatively constant. Alternatively, corporate income taxes only might be reduced.

Even when stability is maintained in this manner, there is still the question of the effects of reduced income taxes upon marginal savings, investment, and consumption. It seems likely that reduced income taxes would raise savings and investment. In the first place, under the conditions postulated, there is a net shift of income from consumers to savers. In the second place, net returns to investment are raised (3). The conditions for a rising demand curve for future income in terms of price (interest rates) are the same as for any other commodity: it must be regarded as inferior to, but highly competitive with, other commodities (present income) while a large proportion of present income is spent on it. Future income is very probably regarded as inferior to present income for the economy as a whole. The proportion of present income saved is not very large for the economy as a whole, and present income is almost certainly not highly competitive with future income. Thus we can take it that a rise in the net return to investment will probably raise both savings and investment.

This argument can be strengthened by an appeal to liquidity- and safety-preference theory. As I have tried to show elsewhere, the "rate of return" which influences investment is a highly complex phenomenon.16 The choice of assets by a capitalist depends upon his safety- and liquidity- preference, and upon the rates of return to be had on assets of varying degrees of safety and liquidity. A reduction of the income tax, unless offset by reduced expenditures that are distributed in exactly the same manner as the tax, increases the rate of return, as we have seen; it also, in its impact effects at least, raises the level of capitalists' income.

It seems safe to assume that for the economy as a whole, "income effects" upon safety- and liquidity-preference are either neutral or positive, over the relevant ranges of income. While some people may indeed feel less pressed to make more money when their incomes rise, and accordingly tend to hold safer and more liquid assets, more will feel that they can now afford to "take fliers." Some evidence to support this thesis can be gleaned from the fact that rich people speculate more than poor people, unless-as in the case of the Irish sweepstakes-there is a very small chance of making a very large gain and no chance of making a very large loss. The tendency for the ratio of "sound investment" to "speculation" to fall off in booms may also be some evidence. Nor do I

'6"A Diagrammatic Analysis of the Supply of Loan Funds" (Econometrica, July- Oct., 1941).

549




think that Mr. Black's argument that an income tax increases the actual degree of uncertainty by changing some prices more than others is of great importance; that is true of any tax.17

We are free, then, to analyse the effects of a lowered income tax in terms of its effect on rates of return. We can visualize two probability distributions, to represent the "rate of return" on a "safe" and a "risky" investment. The reduction in the tax increases the "mean value" of the rate on risky assets more than the rate on safe assets. If a proportional tax of 50 per cent is cut in half, the net rate of return on a "safe" asset with a mean gross return of 3 per cent rises from 1.5 per cent to 1.75 per cent; but the net rate on a "risky" asset with a mean gross return of 6 per cent rises from 3 per cent to 412 per cent. Thus with given liquidity- preference and safety-preference maps, there will be a shift from liquid and safe investments to illiquid and risky ones and the supply of "venture capital" is increased.18

Recent emphasis upon the damaging effects of taxes which discourage "venture capital" implies one of two things: Either the "leverage" effects of investment in new, risky enterprises is greater than for ex-

pansion in established industries, or expansion of existing enterprises will be financed by increased corporate saving and so do nothing to diminish any gap between savings and investment. Professor Schumpeter's well- known theory of economic development provides us with support for the first thesis, recent history of corporate expansion for the second. We conclude, therefore, that income taxes, and especially corporate income taxes, should be reduced in the immediate post-war period.

Inheritance Taxes. Most writers who attempt an analysis of the incidence of inheritance taxes resort to the device of assuming that the

predecessor builds up an insurance fund to meet the 'tax liability on an

7Duncan Black, The Incidence of Income Taxes (London, 1939), chap. xi and

pp. 220-2, 300-12. 18In a frictionless market, the change in relative rates of return would cause marginal

shifts throughout the whole range of assets, including some shift from money to other assets which are "safe" when price stability is expected. If there is uncertainty about

price trends, so that holding cash is regarded as a "risky" investment, the reduction in income tax may conceivably lead to increased cash holdings. However, in terms of

liquidity preference, the result is clear cut, and it seems unlikely that many people would increase their cash holdings because of a rise in "net" rate of return that could be made with a given drop in prices. In the highly institutionalized capital market that we have, such marginal shifts may not take place; but certain types of investor, who make "risky" investments or none at all, will be induced to hold less cash and more assets.

Readers who find this verbal argument unconvincing will find a complete exposition of the diagrammatic analysis upon which it is based in the article referred to above, "A

Diagrammatic Analysis of the Supply of Loan Funds."



Post-war Tax Policy .11-

estate of given size.19 The device is convenient, since it makes an inheritance tax virtually equivalent to an income tax and subject to similar analysis. In our own analytical framework, it would mean that reducing inheritance taxes would raise net profits in the first "day," leading to increased investment in the second "day," particularly in the more risky enterprises.

Unfortunately, the device results in over-simplification. The decedent may not build up insurance, and the effect of the tax on the successors as well as the predecessors requires consideration. Even if the decedent has insurance, a change in the tax may induce him to alter his plans about the size of his estate, and it is not immediately apparent whether he will increase or diminish it. Reducing the tax may make the decedent decide to continue paying the same premiums, and to build up his estate to the size now covered by his policy. In that event, the increase in investment is offset by increased savings, and no reduction in government deficits can be undertaken without lowering national income.

The literature on inheritance taxation has much to say of its effects on the propensity to consume, but it leaves the reader unconvinced.20 As in the case of income taxes, some progress can be made by introducing the law of rising demand curves and liquidity- and safety-preference. Reduced inheritance taxes are in effect a drop in price of "future income for heirs." Unless the demand curve for this commodity in terms of

present income is upward-sloping throughout the relevant range, lower inheritance taxes will result in increased savings. Except for the very wealthy, future income will be regarded as an "inferior" commodity,

19See for example Gerhard Colm and Fritz Lehmann, Economic Consequences of Recent American Tax Policy, Supplement I of Social Research (New York, 1938), p. 93; Ursula Hicks, Finance of British Government, I920-36 (London, 1938); Colwyn Com- mittee on National Debt and Taxation, Report (London, 1927), p. 82. Exceptions are Hugh Dalton (Principles of Public Finance, London, 1936, p. 52) and J. P. Jensen (Government Finance, New York, 1937, p. 408).

20Smith, Ricardo, and B3astable all argued that inheritance taxes are paid "out of capital." Pigou's reply that one might as well say that "a tax on beer is necessarily paid out of beer" does not seem to meet the argument; a tax on beer may very well be paid out of beer (Public Finance, London, 1928, p. 162). The Colwyn Committee also denied that the tax leads to actual capital consumption, but both majority and minority agreed that "it is distinctly more damaging to savings than the income tax" (Report, pp. 189-90). Dalton (Principles of Public Finance) and Colm and Lehmann (Economic Consequences of Recent American Tax Policy) are of the reverse opinion. A. de Viti de Marco-a member of Italy's landed aristocracy-insisted that the "instinct" to ensure continuity of the family is the chief reason for saving (First Principles of Public Finance, trans. by E. P. Marget, New York, 1936, p. 368). From this premise he concludes that the tax reduces savings, but one could surely reach the opposite conclusion from the same premise.

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because of the uncertainty of realizing it, both for the decedent and for the heirs. However, it will not be highly competitive with present income for most people, and few people spend the bulk of their present income on building up an estate. On balance, it seems likely that cutting inheritance taxes would increase savings.

Inheritance taxes almost certainly increase safety- and liquidity- preference. If the decedent insures against his taxes, his savings will be invested by the insurance company in relatively safe, liquid assets. If he does not, either the estate must be in fairly liquid form, or the pro- spective heir must build up liquid reserves to meet the tax, or he must

liquidate the estate at a loss, or he must "invest" in his own inheritance

by borrowing against it and reducing his consumption or his investment in other assets. It seems highly probable that reducing the inheritance tax would increase the supply of "venture capital." My own guess would be that cutting inheritance taxes would increase investment more than savings, but it must be confessed that the results are less clean-cut than in the case of income taxes. Because of the indefiniteness of the

analysis, together with the obvious attractions of inheritance taxation on ethical grounds, I should not be inclined to favour reduced inheritance taxes very strongly, even in the immediate post-war period. Later on, when investment outlets for increased savings may be difficult to find, particularly if the savings are in the form of insurance premiums, the

justification for lower inheritance taxes is still more obscure. Conclusions. Perhaps the most significant conclusion to be derived

from our analysis is that there is no purely analytical basis for supporting tax reduction over increased expenditures as a means of creating income, nor for supporting one kind of tax reduction as compared to another. There is always some form of government expenditure which would

exactly offset the effects of tax reduction as such if the budget is balanced, or which would create the same effects if the deficit is of the same size.

Advantages of tax reduction over increased expenditure arise from

political, institutional, or psychological barriers to a continued high rate of spending. Advantages of reducing one type of tax rather than another arise only when there is some limitation on the form of expenditure, so that by choosing one tax rather than another for reduction a redistri- bution of income is produced, and a difference in "leverage" effects or a

change in the "multiplicand" through induced consumption or investment is obtained as a result. If the tax system is given, one can determine what is the best sort of expenditures for the conditions at hand; if the

expenditure system is given, one can determine the optimum tax system. There seems no simple way of doing both simultaneously.

In our analysis, we have taken the expenditure system as given. On



Post-war Tax Policy

the basis of this postulate, we are able to state certain conclusions, which, however, hold only on this basis:- 1. There is no clear-cut argument for a reduction of general sales taxes immediately after the war or of inheritance taxes at any time. 2. Taxes which restrict consumption of articles for the production of which excess capacity exists should be reduced. 3. Payroll taxes should be reduced in the immediate post- war period and after, but such reductions would have a limited effect in Canada at present. 4. The excess profits tax should be retained, but modified in structure. Provided -the required reduction in total tax collections can be obtained in some other way, collections under the excess profits tax could be maintained or even increased. 5. Income taxes, and particularly corporate income taxes, should be reduced.

TAXES ALTERING MARGINAL CHOICES

Except for the excess profits tax presented in Part I, the tax policies outlined above have relied for their effects upon a change in tax collections and a consequent change in income expectations. Some tax6s, however, can operate by inducing people to change their habits so as to avoid paying them. Examples are the undistributed profits tax, the hoardings tax, and the spendings tax.

The Undistributed Profits Tax. From the welter of argument over the American undistributed profits tax of 1936-9, one conclusion emerges: the tax does tend to increase dividend payments.21 The Canadian law, under which the Finance Minister can order distribution of "excess" surpluses, could produce this effect even more directly if it were utilized. The tax has the advantage, however, of operating continuously and requiring no decisions by the Finance Ministry as to what constitutes an "excessive" surplus for any particular corporation.

The basic questions are, therefore, "How does payment of dividends, in contrast to retention of corporate earnings, affect the propensity to consume and liquidity preference?" To help answer these questions, I have set up the following arithmetic model. Investment is "gross," and stock dividends are excluded by assumption. We shall also assume that

210f 1,151 corporations answering the Brookings Institution survey, 668 said they had increased the percentage of earnings paid out in dividends, 296 said they had not, the other answers being indefinite. Of 857 replying, 636 said the dividends were paid at the expense of reserves for bad years, at least in part; of 848 replies, 604 said reserves for expansion were forgone; 558 out of 835 said they sacrificed working capital; only 132 out of 821 sacrificed funds used to reduce deficits, and only 229 out of 805 postponed repayment of obligations (M. S. Kendrick, The Undistributed Profits Tax, Brookings Institution, 1937). When allowance is made for the obvious efforts of business men to paint the tax black and their own practices white, it seems that the tax modified dividend policies considerably.

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corporations invest their undistributed earnings in their own plant or in securities.

Period Y I C S

1. Original equilibrium.............. 1000 500 500 500 2. New saving..................... 1000 600 400 600 3(a). Retention..................... 1075 650 425 575

(b). Distribution .................... 1025 625 450 550 (c). Equilibrium................... 1000 625 375 625 (d). Equilibrium .............. 1000 600 400 600

In the original equilibrium position, half of income is consumed and half is saved and invested in maintenance of capital. In the second

period, the society decides to save more, and to invest in new capital equipment. In the third period, there are profits of 50 units from this new investment. If these profits are retained and invested by the

corporation, investment rises to 650. However, the stockholders are not

likely to reduce their consumption by 50 units, especially if the new investment took. place in a period of credit expansion and generally optimistic expectations. They will regard the increase in their assets as a source of potential future income, and either deplete cash balances or borrow (buy on credit) in order to increase their consumption. This situation is represented in case 3(a) of the model. In this case, investment exceeds savings and money income rises. If the profits are distributed in dividends, they will not all be reinvested, but probably will be partly reinvested. Consumption will probably increase more than if

profits are retained by the corporation. Investment will increase less; the corporation is not likely to borrow from banks the entire amount of dividends distributed. In this case, illustrated by 3(b), investment

again exceeds savings, and income again rises.

Cases 3(c) and 3(d) represent the equilibrium conditions for increased investment and for maintenance of capital, respectively. The case 3(c), in which expenditure on consumption is actually reduced again, I consider so unlikely as to be of no importance. Case 3(d), in which

consumption remains at the level of the previous period in money terms, would permit an increase in consumption in "real" terms, since the ex-

pansion of plant and equipment would presumably lead to increased

output and lower prices. This case is a conceivable one, although unlikely unless the increased output is so great and the price fall so marked that 400 units of money now buys as much as 500 in the original

period. Such a price fall may have further complications through their effects on business expectations, and so forth.

While the tax is therefore likely to raise C/ Y and I/S, it may reduce



Post-war Tax Policy

A C/ A Y. If the corporation retains profits, thus forcing stockholders to save, stockholders are more likely to spend increases in income from other sources. If dividends are paid out, increases in income from other sources are more likely to be saved. On the other hand, the tax would probably reduce liquidity-preference. Payment of cash dividends would increase the volume of cash held by individuals, moving cash further down the scale of relative marginal significance, and causing shifts into less liquid assets. Shareholders may invest substantial portions of their dividends in their own company, if they regard it favourably.

It would seem, therefore, that the undistributed profits tax tends to raise both consumption and investment, while reducing somewhat the

"multiplier" effects of a given level of expenditures. On the whole, the increased "multiplicand" would tend to outweigh the diminished "multi-

plier," and the tax would have an expansionary effect. It does not seem well suited to the transition period, but would have a place in tax policy designed to sustain national income in face of dwindling opportunities for private investment.

A "Progressive" Tax on Hoarding. Most professional economists have damned the hoardings tax by faint praise.22 Lord Keynes accepts the idea of stamped money as sound, but points out that bank money, debts at call, foreign money, government securities, and even jewelry may satisfy the desire for liquidity. Such criticisms apply, not to the

principle of the tax, but to the incompleteness of concrete proposals for legislation. The answer is, surely, to complete the coverage of the tax.

One of the most complete plans is Arthur Dahlberg's.23 It includes a monthly tax on average demand deposits, currency depreciating through time, cheques that depreciate at the same rate, legal limitations on hold-

ing of coins, and 100 per cent reserves against deposits.24 The defect in this scheme is that the tax would merely drive hoarders into government obligations and other highly liquid assets without directly increasing consumption or investment. I propose, therefore, that the plan be modified to provide a rate of taxation that progresses with the degree of

liquidity. The maximum rate would be applied to cash and deposits subject to unlimited chequing privileges, a lower rate on notice deposits, a still lower rate on short-term governments, a lower rate again on long-

22See for example, E. Despres, "The Proposal to Tax Hoarding" (American Economic Review, Supplement, March, 1939).

23Arthur Dahlberg, When Capital Goes on Strike (New York, 1938). 24Mr. Dahlberg considers 100 per cent reserves necessary to prevent shrinkage in

the volume of deposits through bidding away of bank assets by customers anxious to avoid the hoarding tax. The 100 per cent reserve plan is a weighty matter in itself; my own views on it are expressed in "Comments on 100 Per Cent Money" (American Economic Review, March, 1941). By imposing lower rates of tax on money substitutes, the need for 100 per cent reserves is diminished.

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term governments, and so forth. Any impairment of the government security market could be offset by central bank policy, if it were considered dangerous. In any case, if the tax were successful in increasing consumption and private investment, the scale of government borrowing could be reduced. We have no hoarding tax to reduce at the present time or in the reconversion period, but there is much to be said for introducing a hoarding tax as long-run problems of under-investment and under-consumption reappear.25

The Spendings Tax. Long advocated by Professor Irving Fisher, and lately espoused by some economists in the United States Treasury, the spendings tax seems to have little against it whenever reduced outlays on total consumption are desired.26 Certain exemptions should certainly be permitted, and the rates should be steeply progressive; but there can be little doubt that a tax on income spent would lower the propensity to consume. In wartime, allocation of goods probably cannot be left entirely to consumer choice, and the pressure to increase saving is already so intense that a spendings tax may not raise savings very much. At war's end, when moral compulsion to save may seem much weakened to many people, the spendings tax may prove a highly useful instrument of tax policy. Imposition of a spendings tax at the same time that income taxes were lowered would do much-to stimulate investment while continuing to restrain consumption. M'oreover, as new consumers' goods reach the market, lowering a spendings tax would help to assure an adequate demand for them.

Refundable Taxes. As the supply of consumers' goods increases, refundable portions of personal income taxes can be made available. Refundable portions of corporate income and excess profits taxes might be used as a sort of inverse undistributed profits tax; that is, they might be paid out in the immediate post-war period on condition that they are not distributed as dividends, but are used for investment purposes only.

BENJAMIN HIGGINS

McGill University.

25The failure of dated stamp scrip in Alberta is no proof that a hoarding tax would. be unworkable. The Alberta plan was on too small a scale, the coverage was too limited, publicity was confused, there was no official assurance of permanency, the government did not accept the scrip for all taxes, redeemed scrip was not reissued, no provision was made for conversion of scrip into drafts or currency acceptable in other provinces or other countries-indeed, almost every conceivable mistake was made. Cf. V. F. Coe, "Dated Stamp Scrip in Alberta" (this Journal, vol. IV, Feb., 1938, pp. 60-91).

26See for example, Irving Fisher, "Income in Theory and Income Taxation in Practice" (Econometrica, Jan., 1937); Milton Friedman and Kenyon Poole, on "The

Spendings Tax" (American Economic Review, March, 1943).



Documents

Post-War Tax Policy