Economist David Ricardo on Taxes

Economist David Ricardo on Taxes
February 1, 2004

David Ricardo, born in 1772, became interested in economics at the age of 27 after a chance reading of Adam Smith’s The Wealth of Nations (1776). Ricardo did not become a full-time professional economist until he was 41--after he had amassed a fortune as a dealer in government securities.

Ricardo published the first edition of his magnum opus, The Principles of Political Economy and Taxation, in 1817. In 1819 he was elected to the British Parliament, where he was an outspoken opponent of trade protectionism and advocate for unfettered labor and capital markets. He served until his death in 1823, leaving an estate worth $100 million in today’s dollars. But Ricardo’s greatest legacy was the theorem of comparative advantage, in which he demonstrated the unambiguous and universal benefits of free trade.

Ricardo is lesser known for his theories of taxation, which closely track those of Adam Smith. However, his theory of comparative advantage, like his analysis of taxation, provides a solid foundation for modern principles of taxation, regulation, and public finance.

Ricardo’s Principles of Taxation

Ricardo endorsed Smith’s four tax “maxims”--equity, convenience, transparency, and efficiency. (See “Adam Smith on Taxes,” Budget & Tax News, November 2003.) He agreed that broadly based taxes are more efficient and fair than taxes aimed at specific lines of business or imposed on specific commodities. Like Smith, he denounced all taxes on capital, including inheritance taxes and taxes on capital gains, as “cruel and oppressive.”

Wrote Ricardo: “It should [never] be the policy of governments ... to lay such taxes as will inevitably fall on capital,” since such taxes prevent capital from finding “its way into the hands of those who will best employ it” and “since, by so doing, they impair the funds for the maintenance of labor, and thereby diminish the future production of the country.”

Ricardo agreed that taxes on rents from unimproved land provided the one exception to the principle that “broader is better.” However, he summarily rejected taxes levied disproportionately on landowners because he believed such taxes violate Smith’s equity maxim. Ricardo noted “landlords” often invested “many years of toil” into “the purchase of land or houses” and “it would certainly be an infringement of that principle which should ever be held sacred, the security of property, to subject [them] to unequal taxation.”

Ricardo agreed that consumers, not sellers or manufacturers, ultimately and invariably pay the entire amount of any tax on commodities, though he disputed Smith’s conclusion that sometimes consumers will be required to pay “a considerable overcharge.” Said Ricardo: “[I]t is impossible to conceive that more can be paid by the public upon whomsoever the tax may fall. ... [I]f more is paid, Adam Smith should have stated by whom it is received ...”

Ricardo saved his sharpest criticism for his contemporary, Jean Baptiste Say, who held “that a manufacturer is not enabled to make the consumer pay the whole tax levied on his commodity, because its increased price will diminish its consumption.” Ricardo responded, “Should this be the case, should the consumption be diminished, will not supply be speedily diminished? Why should the manufacturer continue in the trade if his profits are below the general level?” Ricardo did allow that in the very short term some of the tax could be borne by sellers, but he maintained sellers ultimately had to earn a competitive return and would thus withdraw from such unprofitable ventures should consumers refuse to foot the bill.

This is an important issue because many present-day advocates of increased taxes and regulation assert that taxed and regulated sellers and manufacturers will pick up the tab. By contrast, policy economists stand with Ricardo: The full amount of the tax cost--no more and no less--is passed on to consumers.

Ultimately, this is an empirical issue. Historically, the weight of the evidence had been on the side of Ricardo, supporting the notion of a full pass-through to consumers. In the 1980s, however, several economists developed models that predicted Smith’s overcharges in markets where sellers had the ability to influence the price at which their products sold. Recently, Professors Timothy Beasley of the London School of Economics and Harvey Rosen of Princeton University found, consistent with Smith’s theory, that in more than half the cases examined, consumers paid more than the amount of the tax--often substantially more--and that, on average, the pass-through occurs within three months. In none of the cases did consumers pay less than the tax.

Theorem of Comparative Advantage

Ricardo’s greatest contribution to modern economic thought is found in three paragraphs in his Principles. There he demonstrates the benefits of specialization according to comparative advantage. By means of a simple example, he shows that workers in both Portugal and England benefit from trade between the two nations--even if Portugal’s workers are more productive in every occupation. Ricardo proves the wages in both nations necessarily increase with free trade and by specialization in the production of those commodities in which workers are “comparatively” most productive.

Ironically, Ricardo’s proof was based on a flawed labor theory of value--the same theory Karl Marx would exploit to “prove” the supposed superiority of central planning over capitalism. Modern economists, however, have demonstrated that the universal gains from trade also hold in the case of more broadly based theories of value that incorporate the contributions of other factors of production such as capital, technology, and managerial know-how. Importantly, these modern proofs do not require the existence of barriers to the free flow of labor or capital. All that is required is that there be differences between two regions in the costs of production.

It is not possible to overstate the importance of Ricardo’s theorem. As Nobel Laureate Paul Samuelson observes, “This simple principle provides the unshakable basis for international trade.” Indeed, empirical studies show that free trade has been a major force for increased living standards and reduced poverty throughout the world.

Summary and Conclusion

Ricardo’s greatest contribution was in the field of international trade, showing the folly of tariffs and other trade restrictions. However, his insights on taxation are also highly relevant. They confirm the wisdom of Adam Smith that there is no free lunch and that consumers ultimately must foot the bill for taxes and regulations. Ricardo richly deserves his reputation as Smith’s intellectual heir and one of the most brilliant and innovative economists of any age.

As one present-day economist puts it, “The modern economist, reading Ricardo’s Principles, feels rather as a member of one of the Mount Everest expeditions would feel, if arriving at the top of the mountain, he encountered a hiker clad in T-shirt and tennis shoes.” In other words, economics came very easy to Ricardo--as easy as climbing a mountain in a t-shirt and tennis shoes ... which is not very easy!

Tom Walton is an economist with General Motors in Detroit and a member of the Board of Directors of The Heartland Institute.