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. 3 (Aug., 1943), pp. 408-428Published by: Wiley on behalf of Canadian Economics AssociationStable URL: http://www.jstor.org/stable/137254 .

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POST-WAR TAX POLICY

(PART I)

ECONOMIC literature of the past decade suggests, and most economists would surely agree, that there are two fundamental economic

problems: unemployment and monopoly.' Together, enforced idleness of resources and maldistribution of resources due to monopolization of all kinds are responsible for whatever gap exists between actual and potential national real income. They account for a good deal of the inequity of income distribution as well. Economic policy has as its chief concern the elimination of monopoly without loss of efficiency, and the elimination of unemployment without inflation or misuse of resources.

The post-war period will present these two basic problems in aggra- vated form. Exigencies of war have led to increased concentration of industry, which could easily crystallize into enhanced monopoly power. With half our national income now generated by war expenditures, the task of maintaining full employment while shifting production from things that win wars to things that promote welfare will be of unprece- dented magnitude. At the same time, vast new holdings of cash and other liquid resources, combined with the backlog of demand for both consumers' and producers' goods that will have accumulated, will constitute a grave threat of inflation. The balance of the economy, which must be maintained by what Professor Lerner has aptly called "functional finance," will be delicate indeed.2

This article suggests an approach to post-war tax policy designed to meet these problems. While the setting is Canadian, the analytical tools and even the policies proposed would be applicable to the British or American scenes with minor modifications. Part I, which is published in this issue, deals with the role of tax policy in the elimination of monopoly; Part II, which will be published in a subsequent issue,

1Persuaded by Dr. Weintraub's gentle chiding ("Monopoly Equilibrium and

Anticipated Demand," Journal of Political Economy, June, 1942, p. 427), in this article I shall use the term "monopoly" as I previously used the term "non-perfect competition" to mean any type of departure from perfect competition. However, I shall continue to use "monopolistic competition" for monopoly due to differentiation, and "oligopoly" for monopoly due to small numbers of sellers, and "same commodity" will mean technical identity, for the reasons set forth in my "Elements of Indeterminacy in the

Theory of Non-perfect Competition" (American Economic Review, Sept., 1939). "Unemployment" as I use it here includes "disguised unemployment" in the form of a marginal productivity lower than under optimum conditions, for any reason other than monopoly.

2A. P. Lerner, "Functional Finance and the Federal Debt" (Social Research, Feb., 1943).

408



Post-war Tax Policy

with its role in producing full employment. The treatment is necessarily cursory, and-to borrow an expression from Professor Marget-not all the shavings from the workshop have been brought into the showroom. The author has no hope that his findings will prove conclusive, but trusts that they will be provocative.

I

From a purely logical point of view, the best fiscal device for control of monopoly is the one suggested by Mrs. Robinson. She states that a subsidy equal to marginal cost minus marginal revenue for the purely competitive output of a firm operating under monopoly conditions will induce the entrepreneur to produce that output, and that a tax equal to the whole of supernormal profits, including the subsidy, can then be collected without altering the equilibrium position.3 Mrs. Robinson makes no use of the device, feeling that the indefiniteness and instability of demand curves makes it impractical.

Actually, it can be very simply demonstrated that a subsidy per unit of output equal to marginal cost minus marginal revenue for any chosen output x will lead to the production of x, if the entrepreneur maximizes profits and if the demand and cost curves are not altered by the subsidy. Let us denote output by x, total revenue by R(x) and total cost by C(x) and the subsidy per unit as S, which is not a function of x. Then in equilibrium before payment of the subsidy,

R'(x) = C'(x).

3Joan Robinson, Economics of Imperfect Competition (London, 1933), pp. 164-5. Mrs. Robinson attributes the scheme to an examination paper written by her husband. Considering the general acceptance by later economists of Adam Smith's dictum that a tax on profits cannot be shifted and Cournot's clear demonstration that a subsidy on output will lead a monopolist to expand output, it is remarkable that this "tax-and- bounty" scheme should have waited so long for precise formulation.

Professor Dalton, it is true, hit upon the idea of "a tax whose total amount di- minishes with output" as a device for stimulating monopolists to expand production (Principles of Public Finance, London, 1936, p. 60) but this tool is haphazard compared to Mrs. Robinson's. Professor Pigou proposes a system of bounties to industries operating under decreasing costs and taxes on industries operating under increasing costs, both in his Economics of Welfare (chap. XI, London, 1932) and in his Public Finance (chap. vIII, London, 1928). However, he considered his system applicable only under "simple competition," and rejected fiscal controls of monopoly altogether: "Where self-interest works, not through simple competition, but through monopoly, fiscal intervention evidently ceases to be effective. A bounty might, indeed, be so contrived as to prevent restrictions of output below what is socially desirable, but only at the cost of enabling the monopolist to add to his already excessive profits a large ransom from the State" (Economics of Welfare, p. 336). This dictum has been echoed by Dr. Benham in a recent article ("What Is the Best Tax System?" Economica, May, 1942): "Such imperfections should be removed by direct action."

409



410 The Canadian Journal of Economics and Political Science

Let us now pay a subsidy S = C'(x)- R'(x). Marginal revenue with the subsidy is then simply,

R'(x), = R'(x) + C'() - R'(x). Thus if x = x, R'(x)8 = C'(x). That is, when the subsidy is paid, equilibrium is established with output equal to x. By the same reason- ing, a subsidy per man-hour equal to marginal wages bill minus marginal productivity of labour for any desired level of employment n will induce a monopsonistic employer to utilize n man-hours, and so forth; and a tax on profits cannot be shifted.

FIGURE 1

A diagrammatic illustration of the device is given in Figure 1. For this purpose, demand is D2D2 and average cost is (AC - R), marginal revenue is MR2, and marginal cost is (MC - R). If we define x as the

perfectly competitive output (x2 in Figure 1) the subsidy per unit will be equal to BC2 or S. Adding this amount to D2 we get the curve D2 + S. The curve which is marginal, to this one, MR2 + S, will cut (MC - R) in C2, so that equilibrium is established with an output equal to X2. The geometric proof that MR2 + S will cut MC - R in C2 is

simple enough, but too cumbersome to be presented here.



Post-war Tax Policy

An instrument for allocation so powerful on the analytical level deserves examination, despite administrative difficulties which seem more complex than is usual even in the realm of new fiscal policies. The purely statistical problem of estimating the shapes of cost and demand curves is not an insuperable one. It is a problem met implicitly by any business firm, and by any government agency concerned with allocation, no matter what technique is used. Nothing is gained by using other devices which simply fail to make the problem explicit. Given a reasonably stable economy, the general character of the curves could eventually be determined. By a series of trial-and-error approximations, something approaching the right size of subsidy and tax could be estimated. To begin with, both tax and bounty could be set considerably lower than is estimated to be correct. Any move in the right direction would be a net gain, and it would be better to fall short of perfection than to drive a firm out of business altogether. Unless Mrs. Robinson's "indefiniteness and instability of demand and cost curves" are either more deepseated, or a product of the use of the device itself, they do not constitute sufficient reason for abandoning the plan without an analytical trial.4

II

As a general rule, the fiscal authority would define c as the purely competitive output for each firm. Given pure competition in related fields, this output would be the one equating long-run average (and marginal) costs with price, since thfs output then equates relative marginal significances of output with relative marginal displacement costs. Unfortunately, such a definition of x would leave excess capacity in every industry where the demand curve cuts the average cost curve to the left of its minimum, which is probably the typical situation under monopolistic competition, if not in the economy as a whole.

Since we are accustomed to thinking of the "optimum" as a situation minimizing average costs as well as equating average and marginal costs with prices and eliminating monopoly gains, it may be well to state the conditions under which excess capacity is co4mpatible with an optimum situation: (1) technical factors must make it impossible to produce the commodity with a smaller fixed plant at the same or lower average costs; (2) consumers must want a small amount of the commodity badly enough to pay a price covering costs for a small volume of output; (3) relative marginal significance (demand) of the commodity must fall more rapidly than costs, for outputs greater than the one

4A species of tax-and-bounty plan exists in British Columbia law, which imposes a tax on cutting lumber, but grants a rebate on all timber processed within the province.

411




where demand price is equal to or above costs. This constellation of conditions is perfectly possible in the real world, and there is no escape from excess capacity under such conditions except a reduction of the costs of small-scale production or a flattening of demand curves.

If the minimum average cost position were chosen, a net tax could be collected whenever the demand curve cut the cost curve to the right of its minimum point. There is no assurance that the redistribution of income involved in collection of this net tax on profits and, say, corre- sponding expansion of public-work expenditures or reduction of commodity taxes, would not raise the level of satisfaction more than expanding output to the level equating average cost and price. However, in reality it seems likely that more demand curves will cut to the left than to the right of the minimum cost position, and in any case the choice of this position as optimum involves interpersonal utility com-

parisons in a manner which is avoided by defining x as the output equating price with average cost.

Strictly speaking, the costs to which price should be equated are not

average but marginal. Marginal costs are the true measure of alternative output sacrificed if there are any significant differences between

production functions for commodities using the same factors-that is to say, unless costs are constant. However, if we were to define x as the output equating marginal cost and price, not only would excess

capacity still exist whenever the demand curve cuts the average cost curve to the left of its minimum point, but in addition, it would be necessary to pay a net subsidy. Conversely, if demand cut to the

right of minimum average costs, a net tax could be collected. In

reality, it seems likely that a net subsidy would have to be paid in the

economy as a whole. That being the case, the advantage of the output equating marginal cost and price is no longer clear-cut. Even admitting that part of the subsidy could be met by monetary expansion because it leads to increased output, the net change in total satisfaction in

proceeding from the output where average cost equals price to the one where marginal cost equals price depends upon how the remaining subsidy is raised, upon the indifference maps of consumers, and upon the relative importance to the entrepreneurs of money income on the one hand and such things as desire for leisure and to own a big business on the other. Anyone with a strong preference for equation of price and marginal cost as a norm can easily experiment for himself with the tools presented herein, to determine their merits and demerits in terms of his own criterion.5

5While his analysis is somewhat muddled for the contemporary reader by his terminology and by his concepts of "representative industry" and "equilibrium firm,"



Post-war Tax Policy

If unemployment existed among the variable factors and no more productive employment were available, their use in conjunction with the fixed plant of the monopolist would be socially costless. It would pay the society to operate the plant to capacity, even if doing so would require appropriation of the plant by the government or payment of a net subsidy to the entrepreneur. Similarly, if the plant is unnecessarily large from a technical point of view because the entrepreneur lacked foresight or is interested in maximizing returns to the fixed plant, not all rents on fixed factors constitute social costs. The optimum output would then be defined in terms of costs exclusive of these irrelevant rents.

In Figure 1, (AC + R) is average costs including all rents and (AC - R) is average costs exclusive of all rents. In the absence of economies of scale (A C + R) is marginal to (A C - R.) There is always some definition of "factor of production" that will make the production function linear and homogeneous, and in this paper we shall assume that it is. Strictly speaking, the curve of "average costs minus irrelevant rents" would not be identical with the (AC - R) curve of Figure 1, since part of the rents would be social costs-the part required to replace the existing plant with one of the proper size. The true curve would lie between (AC - R) and (AC + R), but would still cut (AC - R) at its minimum point unless diminishing returns set in at a lower level of output for part of the fixed plant than for the rest of it. Since we want (AC - R) for another purpose later, we shall assume for. the sake of diagrammatic economy that (A C - R) is relevant for the case of oversized plant. It will be noted that definition of x in terms of this curve in cases where the monopolist has counted all rents as costs will carry production still further into the stage of diminishing returns if the demand curve cuts to the right of minimum (AC - R), as in the case of D2D2, and will leave the firm with still more excess capacity if the demand curve cuts to the left of minimum (AC - R), as in the case of D1D1.

Where the oversized plant is due to mistaken foresight, but the

Professor Pigou's definition of optimum as the point where "marginal social net product" equals "the central value of marginal social net products" no doubt means the same thing as equation of price with marginal cost. However, his discussion makes it quite clear that he thinks in terms of minimizing average cost more than in terms of equating marginal cost and price. In his "simple competition" context, there is, of course, no conflict between these two norms and the equation of price with average cost. Professor

Pigou also qualifies his support for the scheme with the proviso that "the funds for the bounty can be raised by mere transfer that does not inflict any indirect injury on production" (Economics of Welfare, p. 224) and with the warning that administrative difficulties might outweigh the benefits of the plan (Public Finance, p. 119).

413




entrepreneur does not realize it because he counts all rents as costs and makes a good profit in terms of these costs, production may be carried on and plant fully replaced although the demand curve lies entirely below the relevant curve of social costs, as in the case of D3D3. In such cases, x should be defined so as to minimize [(AC - R) - (price)]x. The tax-and-bounty, however, must be defined so as to leave the entrepreneur a net loss in terms of (A C - R) equal to the social loss in terms of (AC - R). Under these conditions, the tax-and-bounty will yield a net return to the public treasury. It will pay to abandon the plant immediately only if price does not cover prime costs; since prime costs are the same for society as for the entrepreneur, they will presumably be covered in the case under discussion. The tax-and-bounty is simply a means of compelling the entrepreneur to reduce the size of his plant by making him aware of its unprofitability on the present scale. In order to be sure of the right reaction, the tax might be stated as a tax on fixed plant instead of on profits, scaled so as to make the proper-sized plant the most profitable one when subsidy and tax are taken into account.

If, on the other hand, technical considerations prevent the use of smaller plant, but the entrepreneur fails to include rents on fixed factors as costs, there is again a discrepancy between the cost curves determining entrepreneurial behaviour and the curves which measure social costs. The curve relevant to social policy in this case includes rents, and the proper definition of x would entail a reduction in output whenever the demand curve cuts (A C - R) to the right of the point where (A C - R) is at its minimum.

III

While we are concerned with post-war problems, a brief digression on war-time tax policy will serve to highlight certain difficulties also present in peace-time. In war-time, the objective of economic policy is the maximization of the war effort for a given amount of sacrifice, rather than maximization of satisfaction or even of national income.6

'The maximization of the war effort is seldom a single end. The concept of "total war" is a dynamic one which involves increasing sacrifices by the civilian economy as the war progresses. At each stage, the economic problem is to maximize the war effort within, the limits imposed by the willingness to make sacrifices as it exists at the moment. Moreover, the avoidance of post-war disturbances is also a rival aim in most countries, even after several years of war. We are assuming implicitly in this analysis that social policy takes no direct account of the desire to minimize post-war maladjustment, but does so indirectly by taking into consideration any such desires on the part of entrepreneurs, consumers, workers, and so forth, as expressed in their economic decisions. If a government decides that, say, half the national income is



Post-war Tax Policy

Accordingly, x will not be defined as the purely competitive output in the usual sense for every industry. Some firms may be required to operate considerably short of this output, even if considerable excess capacity remains, in order to conserve scarce materials. Some plants may be abandoned altogether. Other firms may be compelled to work well beyond the competitive output, even if marginal costs including user costs are rising very rapidly, because it is too late to devote scarce resources to plant expansion.

For the purpose of maximizing war production, the use of existing plant, equipment, and inventories which will not need replacement during the war should be regarded as costless. Costs will be reckoned in terms of scarce variable factors plus absolutely necessary replacement, maintenance, and repair. The cost of new plant should be reckoned in terms of scarce resources used, spread over the war period according to the probable degree of scarcity at each point of time. By stretching a point, we can call these relevant costs,"prime costs." Assuming the armed forces to compete openly with the restricted civilian demand, the optimum allocation will be the one equating price and average prime costs for each commodity, and x should be defined accordingly.

The entrepreneurs, however, may worry about inability to replace their plants on the one hand, or on the other about being caught with un-amortized and useless plant, equipment, and inventory at the end of the war. The cost curves relevant to their own decisions are different from the cost curves relevant to the social objective. Accordingly, the subsidy and the tax must be defined in terms of marginal cost as the entrepreneurs see it, and not in terms of marginal prime costs as defined above. If the entrepreneurs are monopolists interested in maximizing returns to land and capital as well as profits, who therefore do not regard rents on land and capital as costs, the discrepancy between the entrepreneurial and the social concept of costs will be diminished for existing plant, but increased for new plant.

For simplicity, we shall assume that all existing fixed plant is expected to last for the duration while all inventories must be replaced. Thus the "social cost curve" becomes the curve of average costs exclusive of rents, (AC - R) in Figure 1. The curve of average costs including rents (AC + R) will be marginal to this one.

For firms operating under pure competition, price will equal average costs in both senses at the same output, and no subsidy need be paid all it can ask its people to sacrifice to the war effort at the present stage of the war, and accordingly recaptures half of income paid out by fiscal means, it cannot also determine how the remaining half should be spent, without making the sacrifice greater than the electorate will accept.

415




or tax collected, unless the entrepreneur is operating with still a, third concept of cost. Under monopoly, the total subsidy will equal total tax collections if the entrepreneur ignores rents on land and capital and operates with average costs exclusive of rents.

If a monopolist counts rents as costs, and determines output with reference to average and marginal costs including rents, the authority can collect a net tax equal to C1P1 in Figure 1 in cases where the demand curve cuts (AC - R) to the left of its minimum point, (as D1D1 in Figure 1), but must pay a net subsidy (equal to C2P2 in Figure 1) where the demand curve cuts (AC - R) to the right of its minimum, (as D2D2). In an economy characterized by monopolistic competition with a fair degree of freedom of entry, the former situation will prevail. The authority can therefore collect a net tax from the economy as a whole, and use the proceeds to help finance the war effort.

The demand curve may lie entirely below (AC - R), as D3D3, the entrepreneur continuing in production because he counts rents as costs and enjoys considerable monopoly power. In war-time, such firms must be forced out of business altogether. That is, tax collections must exceed subsidy payments by enough to make production unprofitable.7

Less striking, but essentially similar discrepancies between the social and entrepreneurial concepts of cost will arise in peace-time. They are present whenever the social value of existing plant is less than the discounted sum of expected annual yields, as in the case of slums, or when the social value exceeds this income value with the prevailing distribution of national income, as in the case of hospitals and schools. Such cases call for treatment different from those where prices paid with existing income distribution are regarded as a satisfactory measure of social value.

IV

Some hint of the formidable administrative difficulties lurking behind Mrs. Robinson's "indefiniteness and instability of demand and cost curves" will have been detected in the above analysis.8 There are others, however, which must be mentioned if we are to have a complete

7This case shows how different actual policy might be when equation of marginal cost and price is the accepted criterion instead of equation of average cost and price. For if the former criterion were adopted, with the curves shown in Figure 1, this firm would be subsidized-and-taxed in a manner designed to make it increase its output, instead of being forced out of business as it would be if the latter criterion were followed.

8It is worth remembering, however, that these difficulties are inherent in the problem itself, and are common to all solutions in greater or lesser degree.



Post-war Tax Policy

picture of the practicability of the tax-and-bounty device for control of allocation.

One objection that will surely have occurred to the reader is that under monopoly conditions, the problem is not merely one of determining the shape and position of the actual demand (and cost) curve for the industry as a whole, but also of determining the nature of the actual and estimated demand (and cost) curves for each firm in the industry. Admittedly, there is still a considerable hiatus in the theory of monopolistic equilibrium, much of which arises from the inability to say just how entrepreneurs are likely to behave under monopolistic conditions. One reason for this lack of development may be over-insistence on rigour of analysis, as in the assignment of varying degrees of intelli- gence to entrepreneurs with respect to reactions of rivals to their own price and output policy. By taking a more common-sense, if less scientific, approach, some limits can be set to probable entrepreneurial behaviour.9

Under monopolistic competition, the degree of differentiation is significant; each monopolist can be regarded as producing an unique commodity, and the demand curve for the "industry" and for the "firm" are the same. In this case, the entrepreneur will have as good an idea of the shape and position of his cost and revenue curve as the statistician would before making his study, and would probably adopt the statistician's empirical curves when completed if they were a closer approximation to the actual demand and cost curves than the ones built up by the entrepreneur from his own experience. Thus the problem here is no greater than the statistical one discussed in the first section.

Under oligopoly, there will be n firms all producing commodities sufficiently alike to be regarded as 'the same." Consumers will distribute themselves more or less indifferently among the firms, although each firm may succeed in attaching to itself a certain "clientele" which is insensitive to price changes within a certain range. The relationship between the actual demand (and cost) curves for the industry as a whole and for each firm is less certain in this case, but will fall into one of a few categories:

1. Where any price revision will induce rivals to make a still greater revision in the same direction. Under such conditions, the demand curve confronting each firm would be less elastic for upward revisions of price than the demand curve for the industry, since his share of the total

9Mr. Weintraub has already demonstrated that the estimated and actual demand curves must be the same at the point of actual operation (Journal of Political Economy, June, 1942, p. 432).

417




market would be decreased by a price rise. Because of reduced demand for factors specific to the industry, costs may rise less or fall more than technical factors alone would suggest. This reaction would occur only where costs are increasing rapidly and the clientele is firmly fixed, making the upper end of the demand curve for each firm highly inelastic. It is rather unlikely under oligopoly conditions as here defined. For price cuts, the demand curve for the firm would be less elastic than for the industry. This case is unlikely unless costs are falling and there are no clienteles; under these conditions, it could lead only to "cut-throat competition" which could not persist indefinitely.

2. Where rivals will retain their prices independently of price revision. In this case, demand would be totally elastic for upward revisions of price in the absence of a clientele, and even then would be more elastic than the demand curve for the industry since customers of the "shopper" type would be lost. For price cuts, demand would be more elastic than for the industry as a whole. This case would result when firms have clienteles to exploit and have rapidly rising marginal costs. Except where n is small and factors of production are highly specific to the industry, costs would be determined mainly by technical factors.

3. Where all firms move prices together, through a tacit or formal agreement. In this case, the demand curve for each firm approximates 1/nth of the total sales for each price, and the problem of estimating it is no more difficult than estimating the demand curve for the whole industry. Both technical and price considerations will be involved in cost estimates if any factors are specific to the industry..

It seems probable that most oligopolistic industries would fall in the third category and that in such cases estimated curves would not deviate widely from actual ones in the relevant range. Even in the other two cases, entrepreneurs will usually guess the shape of their own curves as accurately as a monopolistic competitor guesses the shape of the curves for his whole industry, and will probably be able to tell the government statistician what kind of price policy is characteristic for their own firms and for the industry. Thus the existence of oligopoly does not seriously increase the degree of error in estimating the shapes and positions of the relevant curves.

Dr. Sweezy argues that when demand for an oligopolized industry shifts to the right, estimated average revenue curves for each firm become more elastic for lower prices and less elastic for higher prices, since with the expansion of the industry short-run marginal costs will be rising more steeply than before and rivals will be chary of further increases in output.'0 They may follow a price rise, but will hesitate

l?"Demand under Conditions of Oligopoly" (Journal of Political Economy, Aug., 1939).



Post-war Tax Policy

to follow a price cut. Since a subsidy is equivalent to an increase of demand in its effect on marginal cost, it would seem as though the authority must know how the estimated average revenue curve will shift for various amounts of subsidy.

However, the change in elasticity for higher prices is unimportant, since it will not affect the curve of marginal revenue plus subsidy within the relevant range, and Dr. Sweezy's argument is less convincing for price cuts than it is for price rises. Unless the clientele is-large and very firmly attached, each firm will lose considerable business if it maintains prices in face of cuts by rivals. The more rapidly rising costs will be effective only if output is actually expanded, and therefore each firm is likely to follow a price cut by at least enough reduction of its own price to maintain its total sales. Accordingly, the demand curve for each firm is unlikely to become more elastic than the demand curve for the whole industry when demand increases. The consideration of Dr. Sweezy's argument does hot greatly complicate the problem of making trial-and-error approximations to the right tax-and-bounty formula.

In general, it seems safe to say that once the demand curve or cost curve of an industry as a whole has been statistically determined, sufficient information as to the price policy and the cost situation of individual firms could be gathered to proceed from it to the actual and estimated curves for each firm.

Further difficulties arise when the scheme is applied to the whole economy rather than to a few isolated industries. Since the equation of prices and average costs equates relative marginal significances and relative displacement costs only if pure competition exists in all related markets, it would seem that the plan must be applied to all monopolized markets at once, with due recognition of the interactions between them." In fact, to apply the tax-and-bounty rigorously, the authority must have at hand the entire set of general equilibrium equations, including those showing how relative bargaining power shifts with changes in volume and output for every field where bi-lateral or multi-lateral monopoly exists.

Moreover, if the device were applied to every field of enterprise where some degree of monopoly is present, the consequent readjustments would be of a considerable order of magnitude. Competitive as well as monopolistic industries would suffer embarrassment, and transitional

"Some indication of the complexity of these interactions between monopolized markets has been given in J. Dunlop and B. H. Higgins, "Bargaining Power and Market Structures" (Journal of Political Economy, Feb., 1942) and in A. J. Nichol, "Monopoly Supply and Monopsony Demand" (ibid., Dec., 1942).

419




unemployment might reach a level high enough to start a cumulative downswing if not carefully offset by fiscal policy of another sort. In view of the close relationship between "windfall" and "monopoly" gains stressed by Professor Schumpeter, we might also ask whether the knowledge that any supernormal profits would be taxed away might not diminish the supply of "venture capital." Yet if the plan were reserved for the more flagrant monopolies, profits in the chosen firms might be reduced below those in less strong monopoly positions.

Despite these arguments, I believe a case could be made for partial use of the device. All monopolies are by no means equally bad; the damage done by corner grocers scarcely equals the damage done by the construction industry. Whenever there is a reasonable degree of freedom of entry, as in the Chamberlin tangency case or approximations to it, price will not diverge much from average costs. Moreover, there is good reason to suspect that the extent of excess capacity will not be great. The entry of new firms will tend to flatten demand curves as well as push them to the left, so that equilibrium is likely to be established with a low degree of monopoly power and costs close to the minimum. One might very well, therefore, limit application of the tax-and-bounty scheme to cases where monopoly power is high-say where demand curves cut the cost curve to the right of the minimum

point. The consequent increase in total output would be a clear social

gain, and the reactions on the rest of the economy need not be serious, although increased outlays on public work or unemployment benefits may be necessary in the transition period.

It would still be necessary to avoid discriminating against the firms to which the device is applied. Accordingly, the tax might be formulated as a tax on profits in excess of some industrial average. If there is only one firm in the industry, the average rate of profits in some competitive industry with a similar degree of risk might be used as a base. To retain the incentive for efficient production, the tax ought not to reach 100 per cent. This revision of the scheme might also help to avoid discouraging new enterprise.l2

12Further complications arise if entrepreneurs are influenced by other motives besides the desire to maximize profits, especially if the production function is not

linear and homogeneous so that a surplus above the sum of (marginal productivity) X

(number of units) for all factors may exist even under perfect competition. I shall not attempt to deal with these problems here. I have tried to outline an approach to such problems in my "Elements of Indeterminacy"; in a "Reply" to Professor Lynch (American Economic Review, June, 1940); and in "The Incidence of Sales Taxes"

(Quarterly Journal of Economics, Aug., 1940).



Post-war Tax Policy

V

While the administrative difficulties are not so insuperable as to preclude a trial-and-error approach to the tax-and-bounty scheme in industries where the degree of monopoly power is high, they are clearly serious enough to warrant consideration of alternative fiscal devices which, while logically less perfect, are easier to handle in practice. In this concluding section, I shall discuss a few alternatives, in hopes that others may be sufficiently interested to look for better ones.

sc,/

AC' -'C, '

\\D~

0 A41 M1

FIGURE 2

Where monopoly is based solely upon differentiation through in- currence of selling costs, one is tempted to suggest a high tax on selling costs. However, the effect of such a tax in itself is to reduce sales as well as selling costs, so that excess capacity is increased rather than diminished.13 Only if the reduction of selling costs removes the differentiation in the minds of the consumers among rival products, and so flattens the demand curves facing each firm in the "industry," will

13In Figure 2, AC is average cost, SC1 average cost plus the selling cost that produces the demand curve D1, SC2 average cost plus the selling cost that produces the demand curve D2, PP' is the price. SC1 is accordingly the equilibrium average-plus- selling cost, and output is OM1. Now suppose a tax is imposed on selling costs, so that the curve of average costs plus selling costs plus tax which produces the demand curve D1 becomes SC'i, the curve which produces demand D2 becomes SC'2, etc. The equilibrium cost curve will now be SC'2, which represents a lower expenditure on selling costs than SC1, but sales will be reduced to OM2.

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there be any net gain. To assure this result, it might be well to use the revenues from the tax for the support of a government consumers' research organization which would distribute factual material as to the true nature of various commodities on the market.

If differentiation has a technical basis, so that complete knowledge of the nature of rival products would still leave some consumers with a preference for one product over the others, the definition of one product as "standard," and imposition of taxes on products deviating from the "standard," will not necessarily raise the level of satisfaction. If the tax is made prohibitive for the production of deviations from the "standard," the demand curves for the firms producing a given type of product (say, cigarettes) will indeed flatten and the equilibrium

I I

- ---\-- \-----/

I Ii

~-0 2X, XI Ai X?, -I X

FIGURE 3

position will come closer to meeting the criteria of a purely competitive equilibrium. On the other hand, the loss of the "preferred" variant of the product will result in a reduction of consumer satisfaction. It is impossible to say which factor will weigh heaviest in any particular case, but the argument for such a tax policy would be strongest where the technical differentiation seems slight and the degree of excess capacity seems large.

The Report of the Canadian Royal Commission on Price Spreads suggests four "fiscal" devices for regulation of monopoly, in addition to legal reforms.14 The first of these is "Some measure of control over maximum prices,... as in regulation of public utilities." Apart from the well-known difficulties of fixing a "fair" or "competitive" price,

14(Ottawa, 1937), especially pp. 267-8, 494-9.



Post-war Tax Policy

the shortcoming of this type of regulation is that even if the competitive price is fixed, the output will fall short of the competitive level, whenever demand cuts average cost to the right of its minimum. In Figure 3, for example, setting the competitive price P1 as a maximum would lead the monopolist to product xi units, not the competitive output xl, when demand is D\Di.

When combined with an excess profits tax and limitations upon the expansion of plant and equipment, as it is under Canadian war-time controls, price-fixing becomes an effective technique for regulating monopoly in war-time. In Figure 3, let D,Di be the pre-war demand, P2 the pre-war monopoly price. Output is x2. Now suppose that concurrently with the rise in incomes and increase of demand to D2D2, the government imposes a ceiling on prices, with price fixed at the pre- war level, P2. The result will be expansion of output to X3, instead of to xi, as would be the case without the price ceiling. Moreover, most of any increase in profits is appropriated for public use under the excess profits tax. It is my belief that more intensive use of existing plant capacity in rmonopolized industries, more or less accidentally produced by the constellation of war-time increases in income and war-time controls, is one reason for the 150 per cent expansion of Canadian production since war began. While it is less refined than the tax-and- bounty scheme equating price with average "prime costs" as defined in section IIn above, this combination of price ceiling, excess profits tax, and limitation on plant expansion is probably somewhat simpler to administer and is reasonably effective. If it were retained as a measure of monopoly regulation in peace-time, the price set should be a "competitive" price rather than some previous price, and taxes should be imposed on profits in excess of some competitive norm instead of on profits in excess of the pre-war level.

Another proposal of the Price Spreads Commission is "the taxation of excess profits, supplemented by the distribution of such excess between the State and the employees." This device would be a highly dangerous one, since it would give trade unions as well as their employers a stake in monopoly and monopsony positions. When employers and employees join forces to exploit consumers, providers of raw materials or equipment, or other workers, as seems to have happened in the construction industry, the combined bargaining power becomes so great that very serious exploitation can result.l5 The profit-sharing proposal of the

15Cf. Dunlop and Higgins, "Bargaining Power," especially p. 25. On effects of monopoly in the construction industry, see the various Hearings, Reports, and Mono- graphs of the Temporary National Economic Committee, especially Hearings, Part II, Construction Industry, and Towards More Housing, monograph no. 8.

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Commission is a direct encouragement to such "devilish allegiances." A third proposal is aimed at price-cutting by large-scale buyers

such as chain stores. First, a "fair market value" for commodities shall be set, presumably at a level which will provide a satisfactory profit to manufacturers and others selling to monopsonistic retailers or wholesalers. A sales tax of 6 per cent will be imposed on this fair value, mainly for revenue purposes. Then, "If the actual sale price to any purchaser is less than the fair market value of said article, there shall, in addition... be levied... a special sales tax equal to the difference between the said sale price ... and the said fair market value...." The purpose of this tax is to prevent monopsonists from paying such low prices that the sellers are compelled to cut wages, which would reduce purchasing power and lead to unemployment.

.y i .I

! \ Marg-. S54op/y I frt'ce C4C

+ 6', Ths =

1 4 ~~~ .~~I

1 I

,. /I ! c

o x, X X

FIGURE 4

It is clear in the first place that the argument postulates a very special set of circumstances; where the sellers are confronted with

monopsonists with superior bargaining power, but have themselves a

monopsonistic position in the labour market, which enables them to offset reductions in the price of their product by wage cuts, without

lowering the level of employment in their own industry; and where the propensity to consume of the workers is lower than the propensity to consume of the monopsonists, so that the net transfer of income from the workers to the monopsonists reduces total spending.

Granting the possibility of such a pattern, the proposed solution would be a totally ineffective means of dealing with it. As can be readily seen from Figure 4, the effect of the tax is to make the average and mar-

ginal cost curves contiguous with the line indicating the fixed price, which we assume to be the competitive price P2P2, only between S and S'. Accordingly, the equilibrium position is unchanged, both in the



Post-war Tax Policy

commodity and in the labour market. In order to shift the equilibrium position to x, the tax must be designed so as to make the demand curve contiguous with P2P2; the tax must diminish with output by the same amount as the value of marginal product of the commodity to the monopsonist. The knowledge required to design such a tax is no less complex than the knowledge needed for the tax-and-bounty device.

FIGURE 5

The fourth proposal of the Commission, wittingly or unwittingly, suggests the simplest and best method of regulating monopoly which has come to my attention; "the taxation of surplus profits beyond an allowed rate of return on the real investment in utilized capacity." A somewhat liberal interpretation of this suggestion is illustrated in Figure 5. TRl is total revenue, TC total costs, and TP1 total profits. The monopoly equilibrium output is OM1, the perfectly competitive output OC1. Suppose profits are taxed 100 per cent in excess of, say,

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5 per cent on capital value, and that 5 per cent of capital value comes to $OA. The,curve of total profits, or gains, will follow TP1 to G, go along GG' to G', and then along TP1 again. Equilibrium is indeterminate between G and G'. Suppose now that tax-free profits are calculated as 5 per cent of utilized capacity, with "capacity" defined in such a way as to make it vary directly with output. The curve of net gains now becomes OG", and the equilibrium position is where this curve cuts TP1.

In order to establish equilibrium as near to the competitive one as possible, the rate of profit, and the rate at which "utilization" increases with output, should be kept as low as they can be and still have entrepreneurs react to them. The tax must be at or near 100 per cent to guarantee an increase of output with its imposition; otherwise gross profits may fall more rapidly than tax liability as output increases, and no change in output would result from the application of the device.

The attraction of this scheme is its simplicity and its virtually fool- proof character. It is unnecessary to know the exact shapes and positions of the cost and revenue curves, or even to have an accurate definition of capacity. It works equally well for monopsony and for monopoly, and for mixed cases. It is only necessary that profits after payment of taxes should rise continuously with output. Provided the rate at which net profits-rise with output is enough to make the entrepreneur aware of it, a movement in the right direction is inevitable. If, therefore, the tax does not result in any increase in output, it is only necessary to raise slightly the rate of profit which is made tax-free. It is unlikely that output will be contracted below the previous monopoly level, but if output does shrink it can be stopped in the same manner, by raising the profit rate. The worst that can happen is that the rate is left unnecessarily high, and output accordingly falls short of the competitive level to an unnecessary extent.

This device does not give as perfect results as would precise application of the tax-and-bounty scheme outlined in section I above; but it will usually result in an output very close to the competitive one, and it is no more complicated from an administrative point of view than

existing excess profit taxes. An advantage of the proposed system over the usual excess profit tax is that since "utilization" is defined in terms of output, there is an incentive not only to utilize existing plant and equipment more fully, but to operate the part that is utilized as efficiently as possible. To avoid discouraging new enterprise in risky fields, bona fide new firms might be exempt from excess profits taxes for a year or so after production starts, and some allowance for risk might be made



Post-war Tax Policy 427

for all firms by using a ten-year moving average of profits for tax purposes.'6

A somewhat similar proposal has been made by C. Wm. Hazelett.17 He would require every owner of assets to estimate capacity production with their use. At 70 per cent of capacity, present taxes would apply. Tax rates would be progressively higher as output is reduced below this level, and would be prohibitive for withdrawal of assets from production altogether. Tax rates would decline toward zero as output increases, but would become prohibitive for outputs in excess of 100 per cent

capacity in order to deter entrepreneurs from avoiding taxation through under-estimation of capacity. With changes in technique, entre-

preneurs might apply for permission to revise their estimates of capacity. The basic idea of this scheme is the same as the one underlying the

Royal Commission's proposal: to make tax liability decline with output. However, Mr. Hazelett's version is subject to serious drawbacks. In the first place, it would be more expensive to administer. In the Com- mission's plan, the evaluation of capacity is relatively unimportant; there is no harm in a firm producing at 200 per cent of estimated

"capacity." Under Mr. Hazelett's system, a considerable staff would be

kept busy considering applications for revised estimates of capacity. Such applications must be carefully studied and a fair share of them refused, since otherwise every firm would define its current production as 99.9 per cent of capacity at every point of time. If, on the other hand, capacity estimates cannot be easily changed, entrepreneurs will tend to define capacity according to their expectations of demand. If

they expect demand to rise, they will define current output as something below capacity. If they expect demand to fall very soon, they may define present output as over 100 per cent of capacity; and if they expect demand to be stable, they will define current output as approxi- mately full capacity, so that no change in output will result from application of the device.

In periods of unforeseen declines in demand, contrary to Mr.

16In war-time, when differences between the entrepreneurial and the social concept of "costs" are more serious, the adjustments brought about by the use of this device may be too imperfect for safety. The authority could widen the range of control by combining the plan with a price ceiling. By varying the maximum price, the shape and position of the total profits curve, and so the point where it intersects the curve of net gains after payment of taxes, could be moved back and forth over a considerable range of outputs. To obtain production at levels higher than those falling within this range, the authority could allow rebates on increases in output beyond the maximum attainable by the device itself. To encourage production at lower levels, a flat 100 per cent excess profits tax could be combined with rebates on reduced production.

'7Incentive Taxation (New York, 1936).




Hazelett's claim, the system might lead to greater contractions of output than would occur without it, for the simple reason that the tax raises marginal cost over much of its relevant range. If the authority knew just how demand was going to change, it could design a rate of tax regression which would make marginal costs lower than otherwise at the point where it is intersected by the marginal revenue curve; but an authority with the knowledge to do that could just as well impose the much neater tax-and-bounty scheme outlined in section II.

In the Commission's plan, a fall in demand as indicated by TR2 would lead to a fall in output to x2, and might increase the margin between the actual and the competitive output. However, in a period of generally falling demand, the authority would be justified in reducing the exempted rate of profit, and could probably do so without destroying the entrepreneur's incentive to continue in production and to make

profits as high as possible. By reducing the rate of profits exempted from the tax so that the net profits curve becomes OC", the authority could prevent the fall in demand from increasing the spread between the competitive and the actual output. Those who prefer equation of

marginal costs to price as a criterion will be less concerned by the small

gap between the output obtained by this device and the output at which

average cost equals price, since for most monopolies marginal cost will

equal price at a lower level of production than is required to equate average cost and price.

Two administrative problems which the plan would raise are worthy of attention. First, while there is no analytical reason why the output of new plant acquired by existing firms should not be treated for tax

purposes as more intensive utilization of the original plant, such a definition of "utilization" might give rise to misunderstanding. There- fore, to encourage expansion of old firms as well as development of new ones when unemployment threatens, it might be wise to extend

temporary tax-exemption of new plant to bona fide expansion of existing firms. Second, in order to prevent deterioration of quality permitted by the monopolist for the express purpose of obtaining the tax concessions attached to higher output without an equivalent increase in his total

costs, rigorous standards would have to be set and enforced.

By and large, the Commission's proposal as interpreted herein seems as effective a device for monopoly regulation as has appeared anywhere in the literature. I do not believe the administrative complications would be worse than those attached to existing tax legislation, and I believe it would be a much more effective attack upon the monopoly problem than anything possible, under existing law.

BENJAMIN HIGGINS McGill University.



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Post-War Tax Policy