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DEPARTMENT OF

ECONOMICS

Public Finance without Taxation:Free-Riding as Institutional Artifact

Richard E. Wagner

George Mason UniversityDepartment of EconomicsWorking Paper No. 13-05

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Public Finance without Taxation:Free-Riding as Institutional Artifact:

Richard E. Wagner

Department of Economics, 3G4George Mason UniversityFairfax, VA 22030, USA

Tel: ++1-703-993-1132Fax: +1-703-993-1133

[email protected]

http://mason.gmu.edu/~rwagner

Abstract

Expositions of the theory of public finance mostly wrongly assume thattaxation is necessary to finance public goods. Taxation isnt necessary to financepublic goods because free riding is an institutional artifact of the analyticaldichotomy between public and private goods, which prevents recognition ofsocial interaction through the institutions of civil society. Free riding is alsoabetted through the particular institutional presumption that public goods must beprovided by collective entities that operate without alienable ownership. Freeriding is a product of a particular institutional arrangement and is not a universalquality of societal living together. There is a deep similarity between cities andsuch entities as hotels and malls which supply public goods without taxation.Center stage in the theory of public finance can alternatively be occupied by thesocial organization of shared consumption, with taxation relegated to side showstatus.

Keywords: free riding; forced carrying; preference revelation; collective propertyrights; institution-centered public finance; markets and public goods; civil society;political elites; ruling classes

JEL Codes: D23, D71, H20, H41

[Preliminary draft for presentation at Public Choice Society, New Orleans, March7-10, 2013]
mailto:[email protected]:[email protected]://mason.gmu.edu/~rwagnerhttp://mason.gmu.edu/~rwagnerhttp://mason.gmu.edu/~rwagnermailto:[email protected]

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Public Finance without Taxation:Free-Riding as Institutional Artifact:

Taxation occupies center stage in the contemporary theory of public

finance, as the numerous treatments of optimal and corrective taxation illustrate.

This centrality of taxation is articulated cogently in

1955) oft-cited papers that draw a stark contrast between public goods and

private goods. That contrast creates a disjunction between two domains of

economic activity. One is the domain of private goods where market pricing can

operate as envisioned by the theory of free competition. The other is the domain

of public goods that must be provided by taxation through some political process

that is independent of the market process because free riding would prevent

ordinary market processes from generating a supply of those goods. While this

mode of thought has found nearly universal acceptance among fiscal scholars, it

nonetheless universalizes what is really just a particular institutional arrangement

when other arrangements have existed historically and can be understood

theoretically. Indeed, it is acceptance of that particular institutional arrangement

and not analytical necessity that sets taxation in the center of the analytical stage

for the theory of public finance. By exploring how free riding is an artifact of a

particular set of institutional presumptions, this paper explains why the social

organization of shared consumption and not taxation should occupy the center of

the analytical stage for a theory of public finance. In other words, this paper

accepts the manifold existence of public goods and explains how their social

provisioning can be accommodated within an institutional framework that is not

centered on taxation.

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arrangements and processes through which public goods can be and have been

supplied through market-like processes, as illustrated by MacCallum (1970),

Foldvary (1994), and the essays collected in (Beito, Gordon, and Tabarrok 2002).

The common public-private dichotomy reduces reality to an institutional

dichotomy when societies are more accurately characterized as trichotomies.

The missing element in the common dichotomy is the congeries of organizations

various voluntary organizations that undertake collective action. Public finance

theorists have too readily accepted the Samuelsonian lens as the proper way for

posing questions regarding the social organization of shared consumption,

thereby short-circuiting the examination of different institutional arrangements.

Behind this common dichotomy lies the presumption that markets and

governments provide a useful way of thinking about the world we experience.

Part of this mode of thought is driven by the equilibrium-centered reduction of

complex networks of interaction to simple, representative instances of median-

voter choice. While this reduction might seem to bring analytical tractability, it

also distorts the resulting analysis by reducing social interaction to a single act of

choice under two environments. Once, shared consumption is examined within

the trichotomy of market, state, and civil society, taxation recedes in significance

for a theory of public finance, as Wagner (2011, 2012b) sketches. Recognition of

this trichotomy expands the scope for social collaboration in the supply of public

goods. Taxation becomes but a side-show for a theory of public finance because

center stage is occupied by a focus on how alternative institutional arrangements

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European lands. For instance, in Saxony and Prussia, public enterprises

generated nearly 60 percent of public revenue, and with agricultural production

generating up to 20 percent.

Starting late in the 19thcentury, such Italian economists as Antonio De Viti

de Marco and Maffeo Pantaleoni sought to incorporate governmental activity

within the general framework of economic analysis. The animating vision behind

their efforts was a desire to incorporate collective activity within the framework of

the theory of economic equilibrium that was then experiencing substantial

refinement. These scholars sought to incorporate such economic principles as

utility, cost, demand, production, and pricing into a general theory of economic

equilibrium, where politically organized activity was an integral and intelligible

part of the whole story. Indeed, Buchanan (1968), with its title The Demand and

Supply of Public Goods, was an effort to carry forward this Italianate orientation

as an alternative to the Samuelsonian-Musgravian formulation.

De Viti (1888) was an initial formulation in this respect, which he extended

and amplified throughout his career, which included long service as a member of

Parliament, and which culminated in an English translation of his final formulation

a form of pricing that was but one side of the transaction through which collective

all income created a non-discriminatory system of taxation along the lines later

elaborated by Buchanan and Congleton (1998). To be sure, different tax systems

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could generate different patterns of public output by changing the amounts that

different persons would demand, depending on how those differing demands

interacted within a prevailing set of political and fiscal institutions. In this way, De

Viti set forth an initial framework within which public and private activity could be

brought within the same analytical framework, in sharp contrast to the

Samuelsonian formulation.

In referring to taxes as a form of public pricing, this reference is typically

treated more as a metaphorical image than a facet of reality. The benefit principle

of public finance has often been described as a theoretical curiosity whose

applicability is limited to such cases as a city utility company charging residents

for replacing their septic systems with a sewer connection. This description is

misguided because it fails to consider the institutional framework that governs

economic interaction and how this framework influences collective action. De

metaphor but as a theoretical abstraction of actual practice. De Viti was, after all,

for many years a member of the Italian Parliament, and he revised and expanded

his original book twice while continuing to serve in Parliament. It is clear that De

Viti thought that collective outcomes were influenced by the system through

which collective activities were financed, though the relationship between prices

and outcomes were more complex than they were for market outcomes.

With respect to treating tax prices not as mere metaphor but as a

abstraction that was useful in understanding political practice, Maffeo Pantaleoni

(1911) conceptualized society as operating through two pricing systems, a

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There is a striking similarity in form between cities and hotels even if it

seems strange to think in this manner. Hotels operate subways that run vertically,

and which are made available without direct charge. They provide parks of

various types, some with artificial lakes, some with botanical gardens, and others

with yet different types of amenities. The same point can be made about malls,

for malls too provide both individual places of business and amenities that are

made available to the entire public that frequents the mall. A mall is more than

the set of individual shops that it contains, for the mall also provides common

services and amenities that attract customers and increase the value of the

individual shops. In this recognition lies an important lesson for public finance.

Hotels and malls must attract business in an environment of open

competition. To do this they must offer good value in exchange for the payments

they require, and to do so in an environment where they must attract business in

the presence of open competition. This is the central principle of good

commercial conduct. Hotels and malls involve governmental activity of the same

type that is present in the governance of cities. Among other things, they must

make decisions about the type and quality of amenities to provide. Higher quality

might bring more business but it will also be more costly to supply. An ordinary

commercial calculus of cost-and-gain can be brought to bear on the operation of

hotels and malls. Hotels and malls contain governments that provide public

services just as surely as do cities and imperial powers.

The main difference between cities and hotels resides in their capital

accounts. A hotel might be owned by a single person or by many people

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organized into a corporation. Whatever the particular form of ownership, the hotel

faces the problem of having to attract investors and customers in an environment

where those customers and investors have options. In contrast, cities are

organized as cooperatives without alienable ownership. In a democratically

organized city, someone acquires an ownership interest by virtue of residency

and loses that ownership through leaving the city.

A hotel has a market value; a city does not. This difference, however, has

nothing to do with the distinction between private and public goods. The

difference is a product of the institutional framework governing the capital

accounts of hotels and cities (Wagner 2011). For hotels, the capital account is

established through willing participation by investors. Those investors, moreover,

can sell their ownership in one way or another. The most direct and common

form is through the sale of ownership shares on the open market if the hotel were

a publicly held corporation. The hotel could, however, be a partnership or a

closely held corporation. In this case there would be no active market in

ownership, so no explicit market value would exist at any particular moment. Yet

an implicit market value would exist all the same because someone could always

offer to buy the corporation or a part of it, in which case valuation would be

ascertained through the transaction.

By contrast, there is no market value for cities due to the inalienable

character of ownership. All cities have capital accounts, necessarily so, but the

character of those accounts is a product of various institutional features. There

are institutional arrangements that are similar to those that govern hotels. A city

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entails a tied ownership of real estate and city assets. Someone who buys

property in a city is also buying into the ownership of city assets. Since there is

no direct ownership of city assets, the value of those assets is reflected in the

value of real estate. Actions that increase the value of city assets are thus

reflected not in an increase in the market value of the city but in an increase in

the value of real estate in the city. One limiting institutional arrangement is where

owners of real estate have votes weighted in proportion to their property values

and where city activities are financed by a flat tax on property value. This

institutional arrangement would approach that of the hotel, but would still fall

short because people could not specialize in owning cities or owning real estate

inside a city. Other institutional arrangements would widen the gap between

cities and hotels. In any case, free riding does not accompany the provision of

public goods; rather it accompanies the inalienability of ownership in conjunction

with the ability of associated organizations to impose taxes on activities that take

place within their precincts.

3. Mind, Society, and the Entrepreneurial Negation of Free-Riding

While free riding is an institutional artifact and not an inherent quality in the

presence of public goods, that artifactual quality is surely hidden by the standard

dichotomy between public and private goods. That dichotomy envisions the

economic organization of society as occurring through two processes. One

process is the market process where consumption occurs only in consequence of

the exchange of money for service. In this setting preferences are revealed

directly through market prices. In contrast, the public process is envisioned as

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subject to non-exclusion at its core. A supplier provides a service and awaits

payment even though the service can be consumed without payment.

In this presumed setting, free riding is pretty much unavoidable. But it is a

strange setting, though the strangeness of this setting is perhaps obscured by

the blinders created by the standard market setting. For many purposes,

economic analysis can be reduced to a set of choices made by solipsistic

individuals. What we conventionally denote as the market is a form of commons

in which people participate in two roles. In one role they participate in stocking

the commons through providing factors of production. In the other role they

remove items from the commons through their choices about consumption. The

matching of what is produced for the societal commons and what is taken from

the commons is addressed by the theory of economic equilibrium. Given that

matching, the theory allows reduction of society to a set of producer and

consumer choices that are rendered consistent by budget constraints and the

payment of prices.

While the theory of competitive equilibrium allows reduction of society to

the choices of a solipsistic individual, societies are really arenas of interaction

among individuals who are far from solipsistic. When society is treated as a unit

of analysis, matters concerning interaction among persons come into the

analytical foreground, which, among other things, diminishes the significance of

free riding (Wagner 2007). In related fashion, it is notable that in experimental

studies of free riding less free riding is observed when people in the experiment

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interact with one another than when they choose anonymously (McCaleb and

Wagner 1985).

Suppose, for instance, that a mayor forms the idea of hosting an open-air

music and arts festival under the presumption that residents of the city would

value that festival sufficiently highly to make the event worthwhile. Institutionally,

how might the mayor go about doing this? Within the spirit of anonymity and free

riding, the mayor might install collection boxes in private places and ask

residents to make donations. How much or how little a person donates would be

known only to that person. In the experimental literature, some donations are

made even under such circumstances, though they sum to less than what is

Yet no sensible mayor would operate in such a fashion. The mayor would

enlist allies who were of a similar mind about the festival, and these people would

in turn establish an architectural pattern of participation that would be far

removed from anonymity. That architecture could entail cellular patterns of

discussion and contribution where friends ask friends for contributions. It could

also entail publicity regarding the identity of contributors, perhaps even ranking

them by contribution. In these and numerous other possible ways free riding

would be obviated. In any event, an entrepreneurial mayor would never elicit

anonymous donations. Instead, sponsors might be solicited, with those sponsors

given various forms of publicity. While the festival might be open to all, there

could also be places where seating was reserved for patrons who made

significant contributions to support the festival. We would also expect to find that

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those who made larger contributions were those who valued the festival and the

associated activities more highly. Under an entrepreneurial institutional

arrangement, organization of the festival is possible according to the benefit

principle, and the free-riding problem is avoided. Whether the resulting pattern

would correspond to some presumptions of postulated equilibrium is impossible

to determine because those postulated conditions are just theoretical

constructions that do not have existence independently of the relevant process of

social organization (Buchanan 1982).

4. Power, Transaction Cost, and the Persistence of Taxation

While taxation is not necessary for securing a supply of public goods, it

certainly seems to have a robust presence in the financing of collective activities

all the same. Suppose we compare two idealized fiscal regimes: tax finance and

price finance. Taxation shows no signs of giving way to price finance, though Vito

Tanzi (1911) argues that the century-long period of growing taxation has ended.

We may reasonably doubt, however, that tax finance will give way to price

finance even though price finance can be pursued without free riding. How might

the persistence of taxation be explained? There is a clear sense in which that

persistence can be plausibly attributed to its ability to finance collective activity at

lower transaction cost than would be possible with price finance. Yet transaction

cost does not have the same meaning across institutional regimes as it has

inside a particular regime.

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Within a regime based on private ordering, there is clear meaning to

differences in transaction costs associated with different schemes for organizing

transactions because all transactions are voluntary in any case. In the presence

of private ordering (Streit 1992), it would, for instance, be reasonable to speak of

the comparative cost of different arrangements for organizing health insurance

and automobile insurance. If health insurance is organized mainly through

networks of vendor-to-employer relationships while automobile insurance is

organized mainly through vendor-to-customer relationships, it would be

reasonable to ascribe the different relationships as reflecting the operation of

transaction costs because consent among participants governs all transactions.

While at first glance vendor-to-employer relationships might seem to by-pass

consent from empl

as distinct from being able to conscript them.

The situation changes with public ordering because public ordering

operates with an admixture of consent and force, in contrast to the universal

operation of consent with private ordering. Tax finance requires only partial

consent among some controlling subset of people within democratic regimes.

With government involving Faustian bargains (Ostrom 1996), forced carrying

comes into play which does not operate under price finance. With price finance,

supporters of a measure have no option but to attract customers. With tax

finance they can force people to support the measure. Understandably, it is less

expensive to organize transactions through takings than through consent. But

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this difference in expense does not provide reasonable justification for replacing

consent with takings.

Taxation has been a feature of rulership throughout history. It is a

persistent feature of political organization. Following Ostrom (1996), it is

reasonable to think that the terms of the Faustian bargain might vary according to

the constitutive features of regimes. Regimes can plausibly differ in their mixes of

forced carrying and free riding, but forced carrying nonetheless will be present

always in the presence of taxation, save for the genuine unanimity form of the

Wicksellian (1958) suggestion, as distinct from the approximate unanimity that he

ended up advocating.

Pareto (1935) explained that an effective political ideology will activate the

non-logical sentiments of people, inducing them to accept measures they would

have rejected had they thought about those measures, only there is no reason to

think about them because people cannot act upon those thoughts in any case.

Within this ruling class or elite framework, it is reasonable to treat the exercise of

state power as at least semi-autonomous (de Jasay 1985). There may exist

circulation among elites, but custody of state power gives advantage in the

organization of elite-favored activities due to their ability to impose taxes in place

of the need to attract customers. That the use of power is accompanied by

ideological articulations that resonate with common sentiments and thereby

clothes the use of power is easy to understand. What is perhaps not so clear is

the apparent readiness of scholars of political economy is to accept those

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articulations in contrast to piercing the ideological veils, as illustrated by Wagner

and Yazigi (forthcoming).

5. Conclusion

The orthodox theory of public finance has overwhelmingly been

formulated with an eye to mirroring the parasitical qualities of public finance in

large-scale nation-states. While these formulations do have a counsel of realism

on their side, I note only that taxation is imposed not because it is the only way

that collectively useful activities can be financed. It is imposed because the

power contained within modern states allows this method of public finance.

Sufficiently powerful agents can take from others what they want more cheaply

than they can negotiate with them to secure their consent, and this is the

economizing reality of tax finance. What the excursions into welfare principles

and notions of optimal taxation do is provide ideological cover for the deployment

of power that democratic ideology claims to have subdued. Yet people surely are

seldom so innocently engaged as when they are engaging in commercial

activities. It has long been recognized that markets can operate as civilizing

instruments (Hirschman 1977), and the entrepreneurial vision of public finance

would extend the reach of that civilizing process (Elias 2000 [orig. ed. 1936]).

The persistence of tax finance along with its continued theoretical justification

reminds us that the civilizing process has not yet run its course.

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