How Does the Government Raise Money? Tax & Borrow

This article is an excerpt from the Shortform book guide to "The Wealth of Nations" by Adam Smith. Shortform has the world's best summaries and analyses of books you should be reading.

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How does the government raise money? Are taxes necessary? From whom does the government borrow money?

Before governments can spend money on defense, justice, education, or transportation infrastructure, the money needs to come from somewhere. In The Wealth of Nations, Adam Smith identifies two principal sources of revenue: taxation and borrowing.

Continue reading to learn about these two methods of raising money.

Revenue Source #1: Taxation

How does the government raise money? The revenue source we most often think of is taxes. Smith recognizes that it may be impossible to fund important public works without taxes. Therefore, much of his discussion of tax policy is directed toward finding the least disruptive system of taxation.

Smith analyzes three common tax policies: taxing land, taxing profits, and taxing wages. In his analysis of tax policies, Smith acknowledges that, even though taxes are necessary, each method of taxation has its shortcomings.

1. Taxes on land: If you simply tax landlords by the area of land, the tax will fall unevenly because not all land is equally productive. Those making less income off their land will then carry a disproportionately high tax burden compared to those making a lot. However, if you tax landlords by the income they make from their rent, this requires more tax agents to collect that information, making it more expensive.

2. Taxes on profit: Smith argues that businesses will raise the prices of their goods to recoup their losses. Therefore, a tax on profits is actually a sales tax on consumers. This makes it harder to tax proportionally, as profits won’t really be taxed. Smith also states that taxing profit requires a lot of surveillance and tax agents because you need to know how much profit everyone makes. This makes it harder to be cost-efficient. Tax evasion is also possible.

3. Taxing wages: Taxing wages will drive up labor costs for employers. These employers will then try to recoup their costs by raising the price of their goods, thus passing the tax on to their customers. This again makes it difficult to tax everyone’s incomes proportionately through a tax on wages.

Revenue Source #2: Borrowing

Finally, governments can raise revenue for public spending by borrowing it, either from private lenders, other governments, or their own citizens. Smith maintains that government borrowing is a drain on a nation’s economic growth. Because governments will have to pay off this money eventually, borrowed revenue is still paid for by taxation, but in the future. However, it will be paid off at a higher rate because the government must also pay off the lender’s profits through interest.

Therefore, borrowing money pays for the same public works but redirects more private capital in doing so. Because self-interest directs the efficient investment of private capital, government debt becomes a burden on a nation’s economic growth by consuming more of this capital than regular taxation.

(Shortform note: Smith was writing at a time when Britain had taken on enormous debts to finance its military in the Seven Years’ War. While Britain prevailed against their French and Spanish rivals, their national debt had increased to £122 million, about £19 trillion today ($22.8 trillion). Their yearly payments totaled over £4.4 million. To ease the enormous burden of its debt, Britain began increasing taxes on its colonies in the Americas. However, this inflamed tension with the colonies, contributing to the build-up to the American Revolution. Smith concludes The Wealth of Nations by recommending that Britain let go of its American colonies. He contends that they would be of greater benefit to Britain as an equal trade partner that paid for its own defense.)

How Does the Government Raise Money? Tax & Borrow