The Role of the State
in Peace and War
1500-1914
What is the Role of the State?
• What is the role of the state in economic
growth?
• How important is the government relative
to the private sector?
• How big was the government in the past?
Today?
Total Government Expenditure in
Peacetime Years
(Percent of GDP)
France
Germany
Neth.
UK
USA
1715
9
1788
8
1913
9
7
8
18
8
13
12
13
6
8
1950
1987
2000
Total Government Expenditure in
Peacetime Years
(Percent of GDP)
France
Germany
Neth.
UK
USA
1715
9
1788
8
1913
9
1950
28
1987
39
2000
38
7
8
18
8
30
27
42
46
42
43
13
12
13
34
42
39
6
8
21
37
35
US. Federal Government Expenditures
Peacetime, 1997---GDP = $8,110 Billion, G/GDP = 21.3%
$B
%
$B
%
Total Revenues
1692
100.0
Total
1729
Expenditures
100.0
Personal Taxes
754
44.6
National
Defense
458
26.5
Corporate Taxes
205
12.1
Transfers to
Persons
772
44.7
Other Business
Taxes
97
5.7
Transfers to
ROW
13
0.8
Contribution to
Social Security
636
37.6
Grants to
222
States & Local
12.8
Interest on
Debt
231
13.4
Subsidies
33
1.9
Deficit = $37 Billion or 2.1% of Revenue or 0.5% of GDP
US. Federal Government Expenditures
Wartime, 2006---GDP = $13,522 Billion, G/GDP = 19.6%
$B
%
$B
Total Revenues
2407
100.0
Total
2655
Expenditures
Personal Taxes
1044
43.4
National
Defense
Corporate Taxes
354
14.7
Transfers to
Persons
Other Business
Taxes
172
7.1
Transfers to
ROW
Contribution to
Social Security
838
34.8
Grants to
States & Local
Interest on
Debt
226
Subsidies
Deficit = $248 Billion or 10.3% of Revenue or 1.9% of GDP
%
100.0
8.5
Traditional State Finance—War!
U.K. Ratio of Real Military Spending to Real GDP
What is the optimal macroeconomic policy
to carry out a war?
HUGE INCREASE IN GOVT EXPENDITURE
•
•
•
•
•
•
•
•
Y=C+I+G+X
Y=C+S+T+M
so………..
I + G + X = S + T + M, if economy is closed:
G – T = S – I or G = (S – I) + T
government deficit = excess savings
If economy is open
G – T = (S – I) + (M – X), govt deficit = excess
savings plus trade deficit—dual deficits
• Domestic or foreign savers must fund govt.
Optimal Tax Policy
•
To pay for increased spending there are
only three choices
1. Raise Taxes
2. Borrow
3. Inflationary Finance
4. (Requisition)
What is the “problem” with paying
for a war completely with taxes?
• The problem is that taxation is distorting.
• If need very high levels of revenue, it will
require very high tax rates and that may
be counterproductive.
• Thus, if G/GDP = 10% and T/GDP = 10%
prewar, G/GDP = 40% can you raise taxes
by the same amount?
TAXATION
What are the two triangles?
Price
How high can
this tax be
raised?
What is the
maximum
revenue?
Supply
Tax
P2
P1
Demand
Do you care
about
consumers?
G2
G1
Beer
INFLATION TAX
Inflation
For given
nominal
amount of
money…..
10%
5%
What is the
box?
What are the
triangles?
Demand
M/P2
M/P1
Real Balances
Taxes induce Distortions
• If you relied only on one tax---rates would
have to be high. You would tax away the
business or induce a black market.
• But all taxes induce
– Less Production
– Less Labor Supply (tax on wages)
– Less Money Held.
If you are fighting a war you want to make sure that
the economy’s productive capacity is not seriously reduced!
What is the Solution?
What is the Optimal Policy?
•
There are three requirements for optimal tax
policy to ensure that the marginal social costs
are minimized---so that output and welfare are
maximized.
1. Each distortion should impose the same social cost
on each activity---distribute taxes over whole
economy---across sectors.
2. Distortions should be equal over time.
“TAX SMOOTHING” Implies that the government
should borrow for temporary increase in spending.
3. “TIME CONSISTENCY” The government must
maintain credibility that it will pay back what it
borrows.
British Finance approximates optimal
government finance
• John Brewer, The Sinews of Power:
• “From its modest beginnings as a peripheral power…in the
great wars that ravaged sixteenth and seventeenth
century Europe, Britain emerged in the late seventeenth
and early eighteenth centuries as the military Wunderkind
of the age. Dutch admirals learned to fear and then
admire its navies, French generals reluctantly conferred
respect on its officers and men, and Spanish governors
trembled for the safety of their colonies and the sanctity of
their trade. European armies, most notably those of
Austria, Prussia, and minor German states, marched if not
to the beat of British drums the to the color of English
money. Under the early Stuarts, England had cut a puny
military figure, by the reign of George III Britain had
become one of the heaviest weights in the balance of
power in Europe.”
British Deficits nearly match Military Spending
Notice Taxes do NOT spike in war
years……..
War Spending mostly covered by
borrowing---to cover the deficit
Heavy government borrowing leads to higher interest rates--increase savings. It reduces private investment (S-I)
increases to cover (G – T) and induces more labor effort
because work now and save income at high interest rates
for future consumption.
Optimal policy raises taxes sufficiently to cover
increased interest payments and slow reduction of the
debt. A national debt—is how “tax smoothing is
accomplished. And interest should be low.
End of
American
War
End of
Napoleonic
Wars
Inflation Tax?—the Issue of
Credibility
• U.K. on a metallic monetary standard—
first bimetallic, then a gold standard
• Government hesitates to substitute paper
money for specie---public may lose
confidence. Time consistency—inflation
tax diagram…….no surprises.
• Only in major war crises is the inflation tax
used---Napoleonic War and World War I.
Shift to “Paper Pound” in 1797 and 1914.
Two wars with paper money
Inflation and War---but government promises to
retire money and return to original price level!
“Return to Gold at Prewar Parity”
The Importance of Credibility
• The public believes the government’s promise
that they will maintain long-term price stability so
they will hold on to government debt and not
fear real value will be reduced by surprise
inflation.
• They hold on to debt, no panic.
• The British succeed. No spikes in interest
rates..and…!!
• Inflation higher than yield on consols? Negative
real rates for parts of the war….confidence in
return to gold
• British government not penalized...but the
French?
Interest rate premium—Why?
French do not “tax smooth”
A Problem of Confidence: French Crown defaults
in 1716, 1720, 1726, 1759, 1770, and 1793/1797
The
penalty
—high
yields,
high
financing
costs----and less
revenue
for
fighting a
war:
The
Triumph
of British
Finance
Modernization of Tax Systems
• France was unable to generate enough
revenue to avoid defaults and loss of
credibility.
• British’ tax revenues grow more rapidly
(with seemingly little effect on the
economy).
• WHY? Don’t the French keep pace?
The Politics of Taxation
• Great Britain---after 1688, there are regular
Parliaments. The elected representatives vote on
annual budgets. They may alter expenditure and
taxes freely. Regular accounting and presentation of
budgets….that’s why there is annual data in graphs.
• France—after 1614, no meeting of Estates General
until 1789. In absence of meeting, the king may
obtain only temporary increases in taxes from the
Parlement when confronted with war. Some are
permanent but only after Crown threatens the judges
of the Parlement. No regular budgets or accounting.
Budgets are a state secret….that’s why there is
irregular data in the graphs
• British taxes grow with economy---French do not,
hence fiscal problems.
The Administration of Taxes
•
•
Today taxes are collected by a salaried
bureaucracy---known to be efficient.
But use of a salaried bureaucracy depends on:
1. Monitoring. The ability of government to monitor
employees---no corruption, fraud or theft. Ability to
collect information and accounting are vital
2. Risk. The government must be able to accept the
risk that collections will fluctuate as they are not
predictable.
•
If government is very risk averse and has poor
information and cannot monitor its employees,
a salaried bureaucracy will not work well.
Tax Farming or Salaried Bureaucracy
• If the government has poor information and cannot easily
monitor employees and if it is risk averse it employ a
private tax collector or a TAX FARM, where the tax
revenues will be shared.
• If these conditions are extreme, the government will write
a contract where the tax farm will promise to deliver a fix
sum ($) for the right to collect a tax or taxes and it will
keep the excess as profit.
• The government does not have to monitor as there is an
incentive for the tax farm to collect as much as possible
and there is no risk for the government as the fixed
revenue is promised.
• If the conditions are not as severe, the government will
write a contract where the tax farm will share the tax
revenues it collects with the government.
• The government has to monitor a little to make sure that
it is delivering its promised share and there is less risk as
it is shared with the tax farm.
Tax Farming
• Tax farming was common in Europe in the 16th
and 17th century.
• Kings could rely on regular revenue and not
worry about monitoring employees.
• However, if allow tax farmers to assume the risk--they get more of the revenue as compensation,
perhaps 10% of revenue or more.
• The Crown cannot absorb risk easily unless it
has easy access to the capital market.
Great Britain
• Beginning in late 17th century, Britain slowly
moves away from tax farming and starts a
salaried bureaucracy.
• Parliament closely monitors.
• Focus is on indirect taxes, tariffs and excises
(liquor, tobacco, etc) Demand is inelastic and
very little deadweight loss, can carry a high tax
rate.
• British can borrow on short and long term
markets because their last default on the debt is
in 1720.
• They can “smooth” revenues by borrowing.
But, France (and the rest of Europe)
• Tax Farming remains the primary form of
tax collection.
• Indirect taxes are collected by tax farmers
in France, and village based system for
direct taxes on land etc.
• Distrust of government officials.
• No well-developed government capital or
money market, thanks in part, to continued
defaults on debt.
The Burden of Government Debt
Tax
Revenues
(million
livres)
Debt
Debt to
Payments Revenue
(million
(percent)
livres)
1683
1699
1706
119
145
118
22
48
63
19
33
53
1713
1724
1740
1753
131
197
211
257
90
65
57
72
69
33
27
28
1764
1775
1788
322
377
472
124
155
292
39
41
62
Henriet Lease (1756-1762) Revenues, Expenses and Profits(livres)
Second Year
Third Year
Fourth Year
First Year
Revenues
Grandes Gabelles
32,252,980
32,328,757
31,476,174
30,809,517
Petites Gabelles
12,432,598
12,412,758
12,037,037
11,921,168
14,509,003
15,052,629
13,795,115
15,412,469
8,640,763
9,742,661
7,750,646
9,489,546
Tabac
32,412,906
33,422,316
26,059,079
28,748,020
Aides
22,454,862
22,575,391
20,283,847
22,438,997
Domaines
15,728,046
17,724,283
18,164,504
17,578,531
Other farms
14,124,622
14,455,473
13,320,029
13,886,506
Lease Income
152,555,780
157,713,268
142,886,554
150,285,754
Other Income
4,142,429
4,254,143
4,079,616
4,275,685
156,698,209
161,967,411
146,966,170
154,561,439
32,335,994
35,508,795
36,165,739
36,086,110
Net Total Income
124,362,215
126,458,616
110,800,430
118,475,329
Lease Price
110,000,000
110,000,000
110,000,000
110,000,000
14,362,215
16,458,616
800,430
8,475,328
227,972
261,248
12,705
134,529
Cinq Gross
Fermes
Entrees de Paris
Source:
Archives
Nationales G1
54 B Bail d’
Henriet, Etat
de
produits
bruts,
apointments
et frais et
regie.
Total Income
Total Expenses
Profit
Profit per Farmer
Secretary-General
of the French Tax
Farmers: AntoineLaurent Lavoisier
Additional Problems from Tax Farming—
contribute to French Revolution
• Multiple tax jurisdictions with differing tax rates induced smuggling
and required harsh policing by the tax farm.
• Central problem of tax farmer is like a tenant there is incentive
maintain the underlying value of the capital asset.
• In The Wealth of Nations, Adam Smith was the keenest analyst of
the Ferme and correctly identified this problem, anticipating modern
principal-agent theory, he believed that tax farming for profit made
the farmers harsher than any sovereign when punishing evasion,
fraud or smuggling:
• “The farmers of public revenue never find the laws too severe, which
punish any attempt to evade the payment of a tax. They have no
bowels for the contributors who are not their subjects, and whose
universal bankruptcy, if it should happen the day after their farm is
expired, would not much affect their interest.”
• He excoriated the farmers as opulent nouveaux riches, whose
wealth and vanity incited public indignation. This combination of
allegedly high returns to the tax farmers and brutal enforcement
outraged domestic critics and foreign observers of the fiscal regime.
The Central Importance
of Capital Markets
• Without development of capital markets, firms
would find it difficult to raise long-term funds for
manufacturing and commerce.
• Without development of capital markets,
government finance would be woefully
inefficient---unable to “smooth” its tax
collections.
• Where do modern capital markets come from?
• The 18th century reform of government finances
• The cautionary tales of the two Great 18th
Century Stock Market Bubbles—origins in the
War of the Spanish Succession 1702-1713
The Mississippi Bubble
• War of the Spanish Succession 1702-1713
• Disastrous for French finances.
• Debt = 3 billion livres or 18 years of
revenue, interest 2 years in arrears
• Most of debt in form of irredeemable
annuities with high rates 8 to 10%, on life
of individual, non-transferable.
• Government unable to pay defaults---no
source of new credit.
The Regency of Louis XV,
under the Duke of Orleans searches for a solution
• John Law, a
Scottish
financial
writer
appears in
France, after
fleeing a
duel in
Scotland.
Offers a
plan to the
Regent.
• Law proposes and
establishes the Banque
Generale (General Bank)
in 1716. Hopes to
stimulate the economy by
offering loans. But
relatively small, no
observable effect.
• To manage Crown’s debt,
Law establishes the
Compagnie d’Occident or
the Mississippi Company.
It has monopoly trading
privileges with the
promising French territory
of Louisiana.
John Law’s
Scheme
The Mississippi Company
• The Company is also to help Crown with its
debts. It offers to exchange the state’s debt (the
irredeemable annuities) which have fallen in
value with shares in his company. Big benefit for
public—a tradable asset and possible big
dividends from Louisiana trade.
• From the Crown, Law agrees to accept lower
interest payments on the debt, so the Crown
reduces its debt payments.
• Everyone seems better off!
• Worked well, so state allows expansion of
Company to absorb more of state’s debt
The Mississippi Company
• In 1719 the Company merges with the
Compagnie des Indes which has a monopoly of
trade with the Far East and the company is
given more privileges, including the mint and tax
collection.
• In 1719, Banque Generale is reorganized as the
Banque Royale (Royal Bank) and it is given a
monopoly of bank note issue (currency issue).
• The bank grants loans to buy stock in the
Mississippi Company.
Mississippi Bubble
Law’s “System” runs out of control
• There is a run on the bank
• Banknotes declared fiat
money
• Continued expansion of note
issue leads to inflation and
depreciation of livre on the
foreign exchanges and
eventually a collapse in the
price of the shares
• Shares become nearly
worthless as do the notes of
the bankrupt Banque Royale
• Law flees to Venice
Default and Clean Up
• National debt is declared to be reduced to 1.7
billion livres. Face value of debt returned to
level of May 1716, though the interest payments
are reduced.
• Huge damage to reputation of French Crown
and finances.
• Distrust of banks, stocks, and finance.
• No bank chartered again until 1776 and stock
market limited.
• French government finance and financial
development atrophied.
• But was it a fraud?????
The South Sea Bubble
• Great Britain was on the opposite side of
the War of the Spanish Succession 17021713
• Great Britain has huge national debt,
which rises from £16 million to £54 million.
• War largely financed by selling short-term
debt (must constantly be rolled over) and
irredeemable annuities (high interest).
The South Sea Company
• In 1711, two financiers in London propose the
creation of a South Sea Company
• The Company will have a monopoly of trade with
Spanish America and Britain—huge profits
anticipated.
• In addition, the company offers to assist the
government with its debt by exchanging shares
in the company for government debt. The
company will allow the government to convert
the debt from short-term high interest debt into
long-term low interest (6%) debt.
The South Sea Company
• Trading with the Spanish empire is a failure,
but…
• In 1720, the South Sea Company offers to
exchange irredeemable annuities for its shares.
Big benefit for public which gets a tradable asset
in exchange.
• Bribes paid to members of Parliament to ensure
passage of legislation.
• More stock sold…stock booms, with heavy
investment also coming from Paris and
Amsterdam.
Trading is frantic
• An allied
company—the
Sword Blade
Bank. Credit is
offered on
margin to buy
stock.
• Trading booms.
South Sea Bubble
The Collapse
• The Sword Blade Bank---gives loans to
buy stock with its banknotes. Circulation
of notes rise but its reserves dwindle.
• Bank of England accumulates notes of
Sword Blade Bank and then demands that
they convert them into gold coin.
• Sword Blade Bank fails, panic and
collapse of the stock market.
• South Sea
investors ruined.
• Government
rescue
• Company split half
into trading
company and half
into fixed interest
South Sea
Annuities that
government pays--homogeneous,
perpetual and
liquid.
The Clean Up
• Last default by British government. The
government maintains regular payment
on the annuities between 1721 and
1751.
• In 1751 Consolidating Act, combines
all long term debt into Three Percent
“Consols.” Key long-term “deep” liquid,
asset in market for next two centuries.
• British have long-term financial
instrument and short-term Treasury,
Army and Navy notes-----instrument of
“tax smoothing”
• Bank of England eliminates its rival
Sword Blade Bank---maintains its
payment of banknotes into gold,
establish place as the “proto-central
bank.
• Bubble Act of 1720 forbids companies
from activities not specified in charter--effectively prohibits joint-stock
companies until 1824.
• Nevertheless, British finance in all
dimensions becomes superior or
French or continental finance---the
model for all, including the U.S.
Consequences
Bank of England