The Role of the State in Peace and War 1500-1914

1. The Role of the State in Peace and War1500-1914

2. 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?

3. Total Government Expenditure in Peacetime Years (Percent of GDP)

4. Total Government Expenditure in Peacetime Years (Percent of GDP)

5. US. Federal Government Expenditures Peacetime, 1997---GDP = $8,110 Billion, G/GDP = 21.3% $ B % $B % Deficit = $37 Billion or 2.1% of Revenue or 0.5% of GDP

6. US. Federal Government Expenditures Wartime, 2006---GDP = $13,522 Billion, G/GDP = 19.6% $ B % $B % Deficit = $248 Billion or 10.3% of Revenue or 1.9% of GDP

10. Traditional State Finance—War!

11. U.K. Ratio of Real Military Spending to Real GDP

12. 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.

13. Optimal Tax Policy • To pay for increased spending there are only three choices • Raise Taxes • Borrow • Inflationary Finance • (Requisition)

14. 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?

15. TAXATION What are the two triangles? Price Supply How high can this tax be raised? What is the maximum revenue? Do you care about consumers? Tax P2 P1 Demand G2 G1 Beer

16. INFLATION TAX Inflation 10% 5% For given nominal amount of money….. What is the box? What are the triangles? Demand M/P2 M/P1 Real Balances

17. 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!

18. 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. • Each distortion should impose the same social cost on each activity---distribute taxes over whole economy---across sectors. • Distortions should be equal over time. “TAX SMOOTHING” Implies that the government should borrow for temporary increase in spending. • “TIME CONSISTENCY” The government must maintain credibility that it will pay back what it borrows.

19. 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.”

20. British Deficits nearly match Military Spending

21. Notice Taxes do NOT spike in war years……..

22. War Spending mostly covered by borrowing---to cover the deficit

23. 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.

24. 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 Napoleonic Wars End of American War

25. 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.

26. Two wars with paper money

27. Inflation and War---but government promises to retire money and return to original price level! “Return to Gold at Prewar Parity”

28. 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?

29. Interest rate premium—Why?

30. French do not “tax smooth”

31. A Problem of Confidence: French Crown defaults in 1716, 1720, 1726, 1759, 1770, and 1793/1797

32. The penalty—high yields, high financing costs-----and less revenue for fighting a war:The Triumph of British Finance

33. 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?

35. 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.

36. The Administration of Taxes • Today taxes are collected by a salaried bureaucracy---known to be efficient. • But use of a salaried bureaucracy depends on: • Monitoring. The ability of government to monitor employees---no corruption, fraud or theft. Ability to collect information and accounting are vital • 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.

37. 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.

38. 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.

39. 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.

40. 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.

41. The Burden of Government Debt

42. Henriet Lease (1756-1762) Revenues, Expenses and Profits(livres) Source: Archives Nationales G1 54 B Bail d’ Henriet, Etat de produits bruts, apointments et frais et regie.

43. Secretary-General of the French Tax Farmers: Antoine-Laurent Lavoisier

44. 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.

45. 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

46. 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.

47. 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.

48. John Law’s Scheme • 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.

49. 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

50. 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.