New Subjectivist Economic Theory and Public Finance
July 19, 1999
A. Brief History of Subjectivist Economics
B. The Sub-Divisions of Modern Public Finance
1. Theory of Revenue Exaction
2. Theory of Externalities
3. Theory of Public Goods
4. Theory of Public Choice
C. Developments in Economic Theory in Relation to the Subjects of Public Finance
1. Revenue Exaction
a. Inflation and Time Preference
3. Public Goods
a. The Public Goods Problem
b. The Elucidation of Entrepreneurship
4. Public Choice and the New Subjectivism
New Subjectivist Economic Theory and Public Finance
.....The purpose of this paper is to appraise the major developments in public finance during this century from the standpoint of subjectivist economic theory. Subjectivist economic theory differs from professional economics. Subjectivists believe that professional economists have failed to recognize important advances in economic theory.
.....Public finance can be defined as economic theory that is concerned with the particular circumstances that arise when there is demand for goods and services provided by means of government. Both subjectivists and professional economists would accept this general definition. Moreover, both should agree that public finance is a branch of economics. It follows that if important advances in economic theory have not been recognized by economics, they probably also have not been recognized in public finance.
.....While there is some broad agreement by subjectivists regarding the ideologies of professional economics, it is nevertheless true that different self-proclaimed subjectivists have different views. Some of the differences are sufficiently fundamental that one subjectivist may well resent being grouped together with others. Subjectivism ranges from Buchanan's mixture of subjectivism and "positive analysis" to Kirzner's and Lachmann's vision of the market process, to Shackle's extreme individualism, to Mises's methodological apriorism. Given these differences, anyone who writes about subjectivism ought to define it clearly enough that he can avoid being confused with others who claim this name. In this paper, subjectivism refers to what I have called the "new subjectivism." I have claimed that it is basically Misesian, although some might dispute this claim.
.....Besides interpreting the recent history of public finance, this paper makes suggestions regarding how subjectivist economics can help promote changes in professional public finance that are grounded in subjectivist economic theory.
.....This paper combines two fields: public finance and the new subjectivism. Practically no one is familiar with the new subjectivism. And only a small subset of subjectivists are familiar with public finance. Thus, it is prudent to begin this paper by presenting a brief history of subjectivist economics and a survey of public finance. Parts 1 and 2, respectively, are devoted to this task. Part 3 makes connections between the developments in economic theory described in part 2 and the various topics in public finance. Part 4 presents a brief conclusion.
1. Brief History of Subjectivist Economics
.....Subjectivist economics emerged during the "subjectivist revolution" of the 1870s. This occurred as writers discovered the steps necessary to define value in economics. Adam Smith had been concerned with the "wealth of a nation." The capitalist economy, he had said, is a means for members of a society to attain great wealth. But neither he nor those who followed him defined wealth with any precision. As later writers sought to define wealth, or value, more precisely; they were led to focus on the benefits to individuals acting in a particular role -- that of the consumer. Wealth, they believed, should be defined from the subjective viewpoints of the individuals who ultimately consume goods. By making the consumer role the source of value, the subjectivists could not avoid recognizing that wealth is "subjective." That which one individual acting in the consumer role regards as wealth may be regarded differently by a different individual in that role.
.....Given this starting point, the subjectivists were led to ask two questions about a specialized market economy. First, how do consumer evaluations come to be identified? Second, how do the means of production (or prospective means) come to be employed for the satisfaction of consumers' wants. Their answer led to a new procedure for studying relationships in the capitalist economy.
.....The new procedure can be said to consist of three steps. The first is to define fundamental economic terms with reference to specific universal characteristics of human action. Consider the terms consumption, production, saving, and resource-supply. If these terms are to be meaningful in the analysis of the complex market economy, they must refer to actors' own perceptions and choices. A concept of saving for the economy, for example, must refer to the saving decisions of individuals. One might call this first step the making subjectivist or individualist definitions. The second step is to construct an image of the static general equilibrium. In this imaginary, timeless model, utility-maximizing robots are placed in the consumer role. The robots' wants are assumed to be satisfied through the perfectly coordinated behavior of specialized robot producers and resource-suppliers. The third step is to contrast the robots of the model with what an economist can know from intuition and experience to be how human beings would act under the circumstances of the capitalist economy.
.....To the more advanced subjectivist thinkers of the period, the contrast between the static equilibrium and one's intuitive and experience-based conjectures revealed a specific agency, or role, that could not exist in the static equilibrium. This is the role of entrepreneurship, personified by the term "entrepreneur." Thus the role of the entrepreneur emerged as the agency that causes the (prospective) means of production to be used to produce goods for the consumer role.
.....This procedure has been the proper method of subjectivist theory ever since, although few economists bother with the first step and hardly any professional economists today acknowledge that they use it. It consists of elucidating entrepreneurship by demonstrating the various ways that real human actors differ from the robots of the static equilibrium. All developments in economic theory that have their root in the 19th century subjectivist revolution derive from the application of this procedure. It is nevertheless true that the procedure is not ordinarily applied with conscious appreciation.
2. The Sub-Divisions of Modern Public Finance
.....Public finance began as the study of how a government could raise revenue for three purposes: (1) to supply the basic services needed to maintain a market economy, including the policing of property rights and defense against foreign invaders; (2) to supply particular services; and (3) to enrich the sovereign. The idea of raising revenue to supply particular services expanded in the late 19th and early 20th century to include actions intended to correct for various market failures (monopoly, externalities and public goods). Toward the middle of the 20th century it expanded to include macroeconomic stabilization, although later in the century this aspect appears to be disappearing from the field. Around 1960 it expanded again to include the study of democratic decision-making.
From this abbreviated history, we can characterize modern public finance as containing five branches: the theory of revenue exaction, the theory of externalities, the theory of public goods, the study of macroeconomic stabilization, and the theory of collective decision-making. The study of macroeconomic stabilization is probably the most controversial of these. In view of this, stabilization will not be considered further in this paper. In this part, the paper deals with the other branches of public finance in turn.
Theory of Revenue Exaction
.....In order to define and enforce the private property rights of the market economy, legislators and police must ordinarily be hired and paid. In addition, a government ordinarily needs resources to engage in international relations and to protect itself from revolution. This may or may not require the support of a military force. In a monarchy, resources are needed to support the king or queen. In a democracy, resources are needed to support a system of checks and balances on the power of the police, military, and politicians. Ordinary citizens or members of the government may also want to use resources to provide certain goods or services.
.....To obtain the resources needed for these various government activities, the government must have a means of exacting revenue. It would be possible to ask or force people to supply work and other resources. Before the capitalist economy, kings often forced people to contribute goods or labor services. Even today, governments often require people to pay tax in the form of a military draft. However, the theory of public finance has traditionally assumed that a government exacts revenue in the form of money.
.....The study of the means through which the government can obtain money is called the theory of revenue exaction. This is a theory of the effects of different means of obtaining the required money. Public finance economists have traditionally studied different methods of taxation, such as the income tax and the property tax. Other means of obtaining revenue include the inflation of the currency, borrowing, and operation of government enterprises.
Theory of Externalities
.....Public finance economists are naturally interested in arguments that a government can make a positive contribution to the wealth of a society. Two general categories of cases have been studied: the regulation of externalities and the supply of public goods. Each is considered in turn.
.....The theory of externalities refers mainly to negative externalities. Examples are the friction of trains on tracks causing fires and smokestacks spewing dirty air. The economic theory of externalities developed largely out of the partial equilibrium microeconomics of British economist Alfred Marshall. Basically, it consisted of identifying the subjectively determined value of the external cost and then suggesting a type of tax that would force the producer of the externality to take the external cost into account in his profit calculations. Marshall's economics textbook (1890) was the standard in British economics for about forty years. Its ideas relating specifically to externalities were extended by A. C. Pigou (1912, 1920), Marshall's successor at Cambridge.
.....The British partial equilibrium approach is still the standard in introductory textbooks, although there has been a steady decrease in its importance. The reason for the change is the radical transformation in the way the economics profession came to view externalities. The major impetus for the change was the publication of Coase's famous paper (1960). This paper emphasized that the problem of externalities was basically a problem of the absence of property rights. It showed that if property rights can be costlessly defined and enforced, there would be no negative externality problem other than that of searching out and making the necessary transactions to internalize the externality.
.....The subsequent development of the theory of property rights effectively challenged the Marshallian-Pigouvian procedure of suggesting tax and subsidy remedies for situations in which externalities were present. It led economists to focus on the entrepreneurship entailed in creating and redistributing property rights. The emphasis on entrepreneurship is the hallmark of the new subjectivism. For this reason, the British approach to externalities, which overlooked entrepreneurship, can be regarded as incomplete.
.....Special cases of negative externalities are those that effect many individuals at the same time. These are sometimes called collective externalities or public bads. The theory of such externalities bears some resemblance to the theory of public goods, which is discussed below.
Theory of Public Goods
.....The modern theory of the public goods can be traced to Samuelson's famous papers, which defined a public good (1954 and 1955) from the perspective of "welfare economics." Samuelson used the general equilibrium approach and thus superseded the earlier writings of Swedish economist Erick Lindahl (1958), which took a partial equilibrium approach. Samuelson defined a pure public good as one that benefits every community member at the same time. Subsequently, this characteristic was defined as jointness. The benefits of the good or service were said to be enjoyed jointly by all consumers. The theory of public goods supply developed as economists considered the problem of providing incentives for individuals in the market economy to supply such a good.
.....After Samuelson's papers, a great deal of attention was devoted to the fact that examples fitting the Samuelson definition were virtually impossible to identify. Thus economists searched for definitions and classes of goods that contained some of the Samuelson characteristics but which were more evident in everyday life. These include mixed private-public goods, local public goods, and club goods. Particular attention has been paid to the problems of exclusion and monopoly. Can a producer exclude non-payers from participating in consumption? To what extent is monopoly necessary to supply a public good? In analyzing these problems, public finance economists have also considered the special problems associated with enforcing rights to exclude people from enjoying the consumption benefits of a joint good and they have considered ways of dealing with the monopoly problem, including regulation and direct government ownership.
Theory of Public Choice
.....The last part of the modern theory of public finance is concerned with democratic government. In the 18th and 19th centuries, when the European governments were largely autocracies, the king was often charged with the task of supplying "public goods." Economists who advised the government could be certain that the king had the power to implement advice at a minimum cost. Moreover, the king had the power and often the incentive to make sure that his orders were followed. With the gradual expansion of democracy, however, economists could not rely on the person to whom they gave advice to have such power or incentive. A democratic government is likely to receive advice from many people. The implicit belief that sound economic advice would be transformed into law was recognized to be unrealistic.
.....It is evident that a collective decision requires a compromise among individuals with diverse individual interests. As a result, it is costly to make. Given the cost of reaching unanimous decisions, compromises also necessarily entail local inefficiencies. It is impossible to account for preference intensities entirely. And once a decision-making rule is agreed upon, individuals can gain from proposing new decisions or variations in the original decision that benefit themselves at the greater expense of others. In addition, the members of a collective have only a weak incentive to make sure that their decisions are implemented. Economists interested in studying economic policy in a democracy, of which public finance economists comprise probably the largest subgroup, naturally began to analyze the specific problems and costs of causing public goods to be supplied through democratic decision-making.
.....Turn-of-the-century Swedish economist Knut Wicksell seems to have been the first to write about this issue (1896). However, his work was largely ignored. Its discovery by James M. Buchanan in the late 1940s led the latter to ultimately make the problem of democratic collective decision-making a focal point of his public finance. In the 1950s and 1960s, an increasing number of economists began to consider problems associated with achieving efficient "public goods" supply by means of collective decision-making. The result was the theory of collective decision-making, or public choice.
.....One can understand the major portion of public choice theory by comparing an individual's decision to buy a private good with a collective's decision to buy a public good. A single individual can decide to buy a private good by making a single act of will. He then sets aside a sum of money and makes the purchase. To make sure that he receives what he as bargained for, he monitors his use. A collective that is considering whether to buy a public good must have some rule, or rules, for deciding how the individuals' demands, or votes, for the public good will be registered, counted, and weighed. In other words, the collective must have a collective decision-making rule, or set of rules. Once a collective decision is made, a means must exist to collect the money that the decision requires members to pay. A coercive taxing agency is a typical means. Then arrangements must be made to purchase the good or service. A separate purchasing agency is typical. Finally, the supply of the good according to the agreement must be monitored.
All of these activities -- making and enforcing a collective decision-making rule, collecting taxes, arranging for purchase, and monitoring -- are costly. To fully determine whether government supply is more efficient than private supply or than doing without, one must know the specific costs. And to know these costs, one must put himself in the shoes of the various voters, elected representatives, bureaucrats, suppliers of services to the collective, and other prospective beneficiaries and losers from a collective decision.
.....Besides the fact that collective decisions must be made and implemented by a group, there is one other important difference between a collective decision and an individual decision. If a private individual makes an error in judgment, he bears the full burden. Therefore, he has a relatively strong incentive to avoid errors. In the case of a collective decision, the burden of an error is shared by all members of the collective decision-making group. As a result, once a decision-making rule is decided upon, the incentive of any single individual to avoid errors is relatively weak. The result is that the prospect for false information, fraud, and deception are considerably greater for a collective than for an individual.
.....Once economists began to understand the special information and incentive problems involved in making collective decisions in general, they began to look at the various different aspects of this problem. Four relatively distinct, though interrelated, branches of public choice evolved: the economic theory of political institutions, the theory of voting preference revelation, the theory of rent-seeking, and the theory of constitutions. The economic theory of political institutions has been concerned with such things as political parties, parliamentary systems vs. separately elected government branches, and alternative procedures for registering and counting votes. The theory of preference revelation has been concerned with the decision to vote and, more generally, with the problem of obtaining true information about voters' preferences. Rent-seeking is concerned with how individuals can take advantage of the collective decision-making procedures in a democracy to capture either (1) some of the potential gains from a collective decision or (2) other gains that individuals in a market economy are able to make. The theory of constitutions is a combination of theories relating to the use of a government's monopoly over coercion. It is first a theory of the constraints on certain types of government actions, such as the confiscation of property and imprisonment. It is second a theory of rules for making collective decisions such as a tripartite structure of decision-making and a bicameral legislature. It is third a theory of the constraints on individual actions that effect their participation in collective decision-making -- a theory of individual rights such as speech, association, and voting without intimidation.
3. Developments in Economic Theory in Relation
to the Subjects of Public Finance
.....The purpose of this part is to show the relationship between the history of the various subjects in public finance and the new subjectivist economic theory. Each subject described in part 2 is considered in turn.
.....Following the subjectivist revolution of the 1870s and the subsequent development of general equilibrium theory, the theory of revenue exaction became mainly a set of efforts to construct general equilibrium models of the effects of various tax proposals on the roles that are assumed in the static equilibrium model. For example, economists used the general equilibrium model to investigate the effects of sales taxes on consumers, producers, various resource-suppliers including suppliers of work, and savers (tax incidence).
.....Because these studies use the static equilibrium model almost exclusively, they have two characteristics. The first is that they aim to envision the totality of the complex relationships between different consumer-savers, specialized producers, and specialized owners of resources. The second is that they regard individuals in the economy as robots and thus are of no help in comprehending or elucidating the effects of taxes on entrepreneurship. The general equilibrium models are superior to the partial equilibrium models in helping one envision the broad range of effects of a particular tax. However, they do not reflect the developments in the theory of entrepreneurship that characterize the new subjectivism.
.....The only legitimate uses of the static equilibrium model are: (1) to help one form an image of the complex interrelationships between the separate roles and functions assumed in economic theory, particularly the relationship between product markets and factor markets, and (2) to elucidate entrepreneurship. In early writings, I showed that the model helps one understand the entrepreneurial phenomena of appraising resources and the bearing and shifting of uncertainty. In addition, I showed how it enables one to envision an endpoint and thereby better comprehend two aspects of the consequences of entrepreneurship: coordination and synchronization. But the equilibrium model used in tax incidence theory is regarded by its users as a simulation of economic activity. This is an illegitimate use of the static equilibrium because human beings are not robots.
.....The traditional studies of tax incidence, which treat individuals as robots, are, therefore, methodologically flawed. Their findings are only useful in helping to describe a complex set of historical facts such as what happened when taxes were imposed in the past. Their necessary disregard of entrepreneurship means that they are necessarily incomplete in helping to predict the future.
.....For the theory of revenue exaction to make progress in accord with the new subjectivism it must explore the effects of various taxes on entrepreneurial actions. No matter how taxes are imposed, entrepreneurship will, other things equal, seek means of avoiding them. A proper study of tax policy would consider entrepreneurs as avoiders and creators of taxes, as well as passive responders. It would also recognize that unanticipated taxes would pollute the information content of prices, just as unanticipated inflation does (see the discussion of unexpected inflation in the next subsection).
Inflation and Time Preference
.....The theory of revenue exaction has two other major shortcomings due to its neglect of the subjectivist insights. The first is the failure to recognize the effect of a change in the quantity of money on entrepreneurial calculation, as described by Ludwig von Mises (1912). A government may raise funds by resorting to the printing presses or, what amounts to the same thing, borrowing from a central bank that does not take the compensatory action of reducing commercial bank lending power. When this happens, the effect is to change prices "from the outside." Prices change constantly "from the inside." Individuals acting in the entrepreneurial role are continually changing their price offers and acceptances in light of their ever-changing knowledge and expectations. The prices offered by some individuals are a source of information for others who use them as indicators of future market conditions. To the extent that the entrepreneurship of different individuals is correct in its appraisals, the information conveyed by price announcements is also correct. When prices are changed from the outside, however, the information content becomes polluted. Let us suppose that the outside causes of price changes are unanticipated. Then it would be a rare situation indeed if entrepreneurial errors did not turn out to be greater than otherwise.
.....It is important to realize that unanticipated changes cannot be offsetting. It is true that if the price of apples is higher due to an increase in the quantity of money, the seller receives an unexpectedly higher income while the buyer pays an unexpectedly higher price. But the seller and buyer also change their views of the future. Today's prices are indicators of the future. By definition, the entrepreneurs who use the price of apples to help predict the future do not know why they made errors. If they do not find out, they will attribute their errors to the wrong source. The capacity of money to function as an accounting tool is correspondingly reduced. If they do find out, there will be a tendency for entrepreneurship to shift to another form of money or another form of exchange.
.....In an environment of continuing unanticipated changes in the quantity of money, entrepreneurship would create markets that would enable ordinary businesspeople to hedge against unanticipated changes. However, the guaranty needed to support such markets would come at the expense of other business guaranty. As a result, business activity in general would be lower than otherwise.
.....One can imagine a society of robots in which each seller raises his price by the same proportion as the rise in prices. But such an imaginary construct is not relevant to the question of how real entrepreneurship reacts to an change in the quantity of money that cannot be anticipated.
.....It is possible that if the increase in quantity of money occurred on a regular basis and by the same percent, individuals would become accustomed to the changes. It is even possible that individuals would come to know the cause of the inflation exactly. The inflation would come to be anticipated as much as possible. In this event, the increase in quantity of money would not seriously effect calculations. In a free banking regime, individuals would quickly switch to a form of money that was not subject to the increase. An enforceable law against transactions in other currencies could prevent this, however. Thus, through a combination of currency restriction and money quantity increases, a country could gradually implement a partial or full substitute for taxation, as many countries have. But they could not avoid the reactions by entrepreneurs. Entrepreneurs would search out other forms of money and other forms of exchange in an effort to avoid the tax.
.....The second major shortcoming of the theory of revenue exaction is its failure to understand the epistemological roots of the relationship between consumption and saving. Mises's second non-methodological contribution to economic theory was his recognition that every decision to consume is also a decision to save. When entrepreneurship appraises resources, it always thinks about the demands for goods and the supplies of resources by thinking about time. Entrepreneurship uses the market rate of interest to compare its appraisals of demands and supplies in one period relative to its appraisals of demands and supplies in another period. If students of tax incidence recognized these facts, they would have to take account of the effects of taxes and inflation on how entrepreneurs account for consumer-savers' time preferences and on entrepreneurs' comparisons of revenues and costs that are expected at different times.
.....The initial image of the market economy, the pure market economy, contains markets and rights in all goods. As a result, there can be no externalities. To understand how individuals acting in the entrepreneurial role deal with externalities in the "real" market economy, it is necessary to relax the initial assumptions. When externalities exist, entrepreneurship has an incentive to discover them and to create exchanges that "internalize" the externalities.
.....The main error of the Marshall-Pigou model was its failure to recognize that the existence of "Pareto relevant externalities," to use Buchanan and Stubblebine's (1962) term, is due entirely to the assumption that markets and rights to control the benefits and harm flowing from one's actions do not exist in all goods. The British neglected to focus on the fact that traders could create rights because their rigid application of equilibrium analysis diverted their attention away from the notion that entrepreneurs would discover new rights and exchange them. Coase took a more historical, or institutionalist, approach to the problem. By recognizing that in everyday life individuals frequently create new rights in order to internalize what would otherwise be relevant externalities, Coase shifted the focus of analysis toward entrepreneurship, although he did not use this term.
.....The public finance theorist would be wise to travel down the path blazed by Coase and related writers. The study of the creation and exchange of new rights in order to deal with what would otherwise be Pareto-relevant externalities is, in essence, the study of entrepreneurship.
.....We cannot fully know another person's wants or his abilities to satisfy them. However, we take it for granted that others have wants and that they have abilities. Moreover, we are aware from early childhood that two people can obtain satisfaction simultaneously from the same objective event. Thus, we know through experience that the characteristic of jointness, or nonrivalry, in some measure exists. Although we cannot be confident that there is a "pure" public good, in Samuelson's sense, we can imagine a case in which all relevant individuals would benefit simultaneously. Thus, a public good is a subject of economic theory.
The Public Goods Problem
.....Economic theory begins by assuming that the government presents no obstacles to exchange. It also begins by assuming that the rights to all goods are initially possessed by the producer. Under these conditions, individuals acting in the consumer role provide incentives for individuals acting in the producer role to produce the goods that the producers expect to be worth more in terms of money than the costs of production. Prospective producers have no incentive to produce unless they can acquire the right to exclude users or beneficiaries who do not pay. By extension, to the extent that the producers cannot exclude non-paying beneficiaries, their incentive is reduced. The public goods problem arises from the fact that in the case of most goods that seem to possess the characteristics of jointness, although a producer can exclude all consumers by deciding not to produce; he cannot exclude buyers selectively. If he supplies the good to one, he must at the same time supply the good to others. The result is that many potential buyers are also potential "free riders." From a prospective buyer's point of view, there are two ways of enjoying the benefits of the good: (1) help provide an incentive to a supplier to produce the good by offering to pay at least part of the total bill or (2) wait until others provide the incentive. In the case of a non-joint good, the second alternative does not exist because the jointness characteristic is absent.
.....Intuition and experience tell us that a prospective buyer of a joint good has less incentive to help provide the producer with an incentive to produce than he would have if the good was a non-joint good. As entrepreneurship recognizes this fact, it is led to attempt to identify particular rights-creating or market-creating actions that would cause the production incentive to be raised.
The Elucidation of Entrepreneurship
.....To the new subjectivist, the "public goods problem" presents an opportunity to elucidate entrepreneurship. Before discussing this, it is important to realize that entrepreneurship incorporates much more than simply the decision to produce or not to produce a good. A person's entrepreneurship enables him to recognize that a particular item or service may yield utility to consumers, it discovers and informs others about the possibility of gains from consumption, it teaches prospective consumers how to use a product, it makes and accepts offers, and it positions itself so that these actions can take place. In addition, it creates rights that provide incentives to produce or supply resources. Moreover, entrepreneurship is not limited to producers. The prospective consumers of a good also exercise entrepreneurship by, among other things, helping to facilitate a trade. From this point of view, the "public goods problem" is an incentive problem. The entrepreneurship that prospective buyers of a joint good can potentially exercise in their efforts to enjoy the benefits of the good faces conflicting incentives, as described above.
.....Consider now the opportunities presented by the "public goods problem" for elucidating entrepreneurship. From the standpoint of the producer alone, one way to deal with the public goods problem is to search for ways to exclude non-payers. Innovative methods of fencing or otherwise blocking consumer benefits can be discovered. A producer may also discover new ways to monitor use. Finally, the producer may be able to discover a non-joint good that can yield similar benefits or to link the good's supply to some other good whose supply he can monopolize. From the standpoint of potential consumers, a solution may be to form buyers clubs in which decisions to buy are made collectively and each member is subject to payment rules. Buyers may also submit themselves to arbitration rulings. In other words, they may agree to abide by the ruling of a hired arbitrator if he rules that they should pay particular sums of money for a good that a producer claims is public. There are undoubtedly many other ways in which a producer and buyers can deal with the exclusion problem. Of special importance is pre-production interaction, such as a prospective seller calling a meeting among prospective consumers in order to describe alternative ways that they might make a collective buying decision. Another way is to purchase and then later resell or rent the use of property, the ownership of which is necessary in order to benefit from the public good. The purpose here is not make a catalogue but to illustrate why public finance economists should take account of entrepreneurship.
.....The new subjectivism focusses on entrepreneurship first. This distinguishes it from the approach proposed by Samuelson and followed by most public finance professionals. That approach constructs models of robots without much thought of how entrepreneurship would resolve the public goods problem.
Public Choice and the New Subjectivism
.....Public choice was described in greater detail in part 1 than the other branches. This part focusses on its relationship to the new subjectivism. As mentioned, the new subjectivism considers the question of the role of government only after it has elucidated entrepreneurship in the unhampered market economy. Since public choice is concerned entirely with the problems of government decision-making, it would appear that subjectivist economic theory, as defined above, is not relevant to public choice. It is nevertheless true that at a more fundamental level, the methods of economic theory are identical to those of public choice. These methods include (1) making the a priori assumptions that human beings possess means and ends, that they have a sense of time, and that they operate under physical, intrasubjective, and intersubjective uncertainty; (2) methodological individualism, and (3) the use of the method of imaginary constructions to contrast a function-performing model of robot behavior with inventive, innovative, understanding (in the sense of verstehen) choice-making.
.....A useful comparison of subjectivist economic theory and public choice is the following. Economic theory is the study of the distinctly human part of action under the conditions specified in the definition of the market economy. Public choice theorists have studied the distinctly human part of action under the conditions of a democracy. Subjectivist economic theory constructs a model of static equilibrium that is populated by robot consumer-savers, resource-suppliers, and producers. The aim is to elucidate entrepreneurship, which is not robotic. Similarly, the theory of public choice begins with a model of static democratic government populated by robot voters, robot elected representatives behaving in the role of government officials, robot bureaucrats, resource-suppliers to the government, and robot producers of goods demanded through governments. The public choice model assumes national defense expenditures, property rights expenditures, redistribution programs, and possibly other specific government programs. The challenge of public choice theory is to elucidate the distinctly human action that one can expect to be performed by real human actors in their roles as voters, elected representatives, etc.
.....The ultimate goal of subjectivist economic theory is to evaluate government programs when the evaluation requires an understanding of the market economy. The ultimate goal of public choice theory is to evaluate democratic rules or institutions when the evaluation requires an understanding of democratic political interrelationships.
.....The initial focus of economics is entrepreneurship, which is assumed to facilitate mutually-beneficial trade. Thus the economist begins with an image of an economy in which all goods are private goods and private property rights are fully defined and enforced. In considering externalities and public goods, the economic theorist is led to focus on other aspects of human action like opportunism, deceit, and free riders. Because public choice studies collective decision-making within the context of a functioning democracy, property rights are subject to negotiation at the outset. As a result, opportunism, deceit and free riding are studied from the very beginning.
.....The economist studies human action under the assumption that the interactors are at peace. The public choice theorist could do the same. However, a desire for realism may lead him to begin with a model in which it is necessary to spend resources for national defense and law and order.
.....There are other parallels. However, a discussion of them would be beyond the scope of the present essay. The main point is that both economics and public choice are branches of what Mises defined as praxeology, the study of distinctly human action. Therefore, both use the same fundamental methods of elucidating phenomena.
.....This paper has shown in broad strokes the relationship between the new subjectivist economic theory and public finance. The changes in economic theory that the author has called the new subjectivist revolution began in the late 19th century. Disregarding stabilization policy, these changes only began to penetrate the thinking of public finance economists in the years following Coase's 1960 paper. Since that time, economists have increasingly sought ways that externality and public goods problems can be resolved through entrepreneurship, although they have not used this term. It is possible that continued developments will lead public finance economists to comprehend the significance of the earlier changes in economics.
.....Modern tax theory is largely mathematical and statistical. Tax theorists have, of course, recognized the effects on entrepreneurial incentives. Their main conclusion is that a tax on any behavior, or its consequences, tends to reduce the incentive to perform that behavior. Some attention has been paid to tax avoidance. The most important lesson from the new subjectivism about tax avoidance is that the incentive to avoid is greater than the incentive to detect avoidance due to the fact that detection is a public good. Public choice theorists can be credited with this insight. We also discussed the effect of government financing by means of unanticipated inflation on entrepreneurial errors. We noted that hedging against anticipated price level changes diverts guaranty funds from private business to speculation.
.....In addition to Post-Coasean developments, the field of public finance has been broadened to include public choice. This subject has no traditional roots in economics although it uses the same praxeological framework. Suggests were made in part 3 about how the praxeology of the new subjectivism could be used to help direct the research of the pioneers of this new field.
1. See Mises, 1981, Ch. 4.
2. Much of the early work on this subject was done in reaction to the socialist and Marxist claim that those who appeared to be responsible for causing the means of production to be employed were unjustly rewarded. Because many authors explicitly stated their desire to vindicate the market economy, their work appeared to some to be a justification for the existing social, political, and economic order. Regardless of one's views on that subject, there is no doubt today that these pioneers were led to discover a completely new procedure for comprehending the complex economic interaction of a specialized market economy.
3. J. B. Clark referred to this step as the first division of economics -- the construction of "a distinct set of economic laws, the action of which is not dependent on organization." Clark regarded these laws as "universal."(1899, p. 26) Mises (1966) later went much deeper than Clark by associating the "economic laws" (more correctly definitions) with the fundamental characteristics of the a priori category of human action. See Gunning, 1997.
4. In the early writings on general equilibrium, the term "static" was set in contrast to the term "dynamic." Economists defined dynamic elements as those associated with entrepreneurial profit-seeking. See Clark, 1899, for example. Later, professional economists opted for a totally different meaning. This is the idea of a behavioral model that contains time subscripts.
5. The idea of entrepreneurship as agency was most fully developed by Davenport, 1914, and Knight, 1921.
6. The procedure, which the author has called the "new subjectivism," was first described by Ludwig von Mises. The interested reader can refer to Gunning, 1990, 1992a, 1992b, 1993, 1994, 1996, and 1967 for more detailed descriptions.
7. A third is the monopoly problem. The writings on this issue have developed separately from public finance, however, and will not be considered in this paper.
8. This point had been made earlier by a number of writers, including Americans Alan Young (1913) and Frank Knight (1924), and by Austrian Ludwig von Mises [1949 (1966)].
9. See especially a series of papers by Demsetz (1966, 1967, 1972a, 1972b).
10. See Buchanan, 1975, p. 385.
11. This approach was incorporated into his much neglected book Public Finance in Democratic Process (1967).
12. There are several surveys of this field. For brief surveys, see, Buchanan (1975) and Tullock (1987). For a more detailed description, see Professor Mueller's 1989 survey.
13. It is possible, of course, that the collective will want to more directly control supply by hiring employees in a bureau to supply the good. We will not discuss bureaucratic supply in this paper.
14. On rent-seeking, see Tullock, 1987. On the study of constitutions, see Buchanan, 1987. On other subjects and on the field of public choice in detail, see Mueller (1989).
15. See Gunning, 1990, chapters 6 and 12 respectively.
16. To the extent that such activities are useful at all, I suspect that it is because they present statistics on unemployment and national income in a way that professional economists can easily remember as a result of their training. Since such statistics are the main referents for defending the relevance of theories, both casual and academic, professional economists are expected to know them. Of course, there are much simpler ways of remembering such statistics than to spend years learning mathematical modelling and statistical techniques. And, of course, the usefulness of such statistics in accomplishing anything that ordinary people would regard as worthwhile is problematic.
17. Examples are markets for durable assets and price-level indexed contracts.
18. This discussion is unrelated to the idea that monetary policy can be used for "stabilization." Any attempt to change the quantity of money (or taxation for that matter) unexpectedly will cause entrepreneurial errors. Professor Rothbard (1975) has used this reasoning, which can be traced to Mises's 1912 book, to explain the Great Depression. Both these economists warned against the use of inflation for revenue exaction. Their warnings appear to stem from an implicit realization that because inflation is cheap and easy, it provides a more serious threat to the system of property rights upon which the capitalist system is based. Rothbard especially viewed inflation as a means of theft. Of course, he also sees taxation as a form of theft, but the latter is more visible to the victims. Rothbard's is basically a public choice theory.
19. See Mises's discussions of saving in Mises, 1966. His first was the discovery of the relationship between prices and economic calculation, on which his theories of the trade cycle and socialism were based.
20. See Gunning, 1990, chapter 12.
21. The British error was, at first glance, twofold. First, it used the partial equilibrium approach, which had been effectively debunked about the same time that Marshall's textbook became popular. Second, it adopted a statist view of the externality problem, thereby disregarding entrepreneurship. It is worth noting that the Marshall was an avowed positivist, who sought to describe institutions without first developing the methodological underpinnings in theory. This may have led him to disregard developments in economic theory. And his status in British economics made it beneficial for his successors to also disregard them.
22. As pointed out earlier (see footnote 4), Young, Knight and Mises had recognized the flaws in the British analysis and had recommended that externalities be viewed from the standpoint of inadequately or incompletely defined property rights. Knight and Mises especially went further and recognized that the whole problem of external effects should be studied from the standpoint of entrepreneurship. However, these economists were unable to muster the following of Coase. Thus, the major developments have occurred after 1960. Because Coase and his followers have not emphasized entrepreneurship in the subjectivist sense and also because of their positivism, there is still some danger that future property rights theorists will neglect entrepreneurship.
23. Objective here means observable or measurable in accordance with the methods of natural science.
24. See Gunning, 1990, chapter 13.
25. See the interesting discussion by Foldvary, 1994, on how the Disney Corporation was able to capture many of the external rents due to its supply of the Disney World complex in Orlando, Florida.
26. See Mises, Chapter 1, for the definition of praxeology. Gunning, 1991, discusses the branches of praxeology.
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