Taxation, Public Finance, and Public Debt
Taxation, Public Finance, and Public Debt
TAXATION, PUBLIC FINANCE, AND PUBLIC DEBT
Crises in taxation and public finance often cause major political transformations. The U.S. Constitution is one such case. Its adoption and the ensuing policies pursued by the Federalist administration under George Washington (1789–1797) in turn brought dramatic and controversial changes in the American fiscal and financial regime. These reforms became a permanent fixture of the political economy of the early Republic. Despite vociferous criticism of Federalist policy while in opposition, the Democratic Republicans made only minor changes to the fiscal and financial system after they came to power. By far the most important changes in taxation, public finance, and public debt management between the founding and the Age of Jackson took place within a few years of the adoption of the Constitution.
taxation and expenditures
When the Constitutional Convention convened in May 1787, the nation's public finances were in a critical state. Under the Articles of Confederation (drafted in 1777, ratified in 1781), Congress had no power to tax but had to requisition funds from the state governments to meet expenses, above all the payments on the public debt created by the War for Independence. After the war, most of the states adopted ambitious tax programs to raise money for these requisitions and for servicing their own debts. While these taxes gave rise to hardships and protests, among them Shays's Rebellion in 1786–1787, they did not generate much money for Congress. Instead, popular protests made the state governments put an end to their tax programs, and by early 1787 money had virtually stopped flowing into the federal treasury. Congress could not pay its handful of civil officers or its few troops. Nor could it honor the claims of its creditors and therefore had difficulties raising new loans. This was a matter of great consequence: like modern wars, eighteenth-century wars cost enormous amounts of money. And like modern wars, they were paid for with borrowed money. A government unable to borrow money was therefore in a dangerously exposed situation in the event of a crisis that might lead to war.
Article I, section 8 of the Constitution gave Congress the power to "lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defense and general Welfare of the United States." The only constitutional restrictions on federal fiscal power were that duties had to be uniform throughout the Republic; that any direct tax had to be proportionate to the census; and that no duties on exports could be imposed. Under the leadership of Alexander Hamilton, who served as secretary of the Treasury from 1789 to 1795, the Federalists used Congress's new power to completely restructure the American fiscal system.
Eighteenth-century American governments implemented three basic types of taxes: direct taxes on persons and property; excises on retail sale and production; and customs duties. In most of the states the most important taxes in the 1780s were on persons and property. Excises, particularly on spirits, were used in many of the states, but they raised only a minor part of total revenue. Customs duties were important in some states, particularly New York. The Federalists were well aware that the direct taxes which the states had levied had been both unproductive and unpopular. They also knew that there were strong objections to excise duties because they required a high level of supervision and control. Finally, they knew that customs duties were regarded as a light form of taxation and that there was general support for granting Congress an independent income in the form of the impost. This led them to create a fiscal regime that relied almost exclusively on customs duties to raise federal government revenue.
Apart from the Quasi War (1798–1800) and the War of 1812 (1812–1815), customs duties accounted for more than 90 percent of total federal tax revenue between 1789 to 1829. For long periods (1804–1813, 1822–1862) it was the only federal tax levied. It was a very productive tax: in 1792 alone, the receipts from customs duties, $3.4 million, superseded the total amount paid by the states on Congress's requisitions between 1781 and 1787. As American trade grew during the Wars of the French Revolution (1793–1801) and the Napoleonic Wars (1803–1815), the income from customs duties grew as well. In constant prices, the annual income had doubled by 1800 and grown fourfold by 1807. The following fifteen years were volatile, but by the end of the 1820s customs duties had reached a level twice that of 1807, or roughly $23 million.
Internal taxation played only a minor part in the Federalists' fiscal system and created far more conflict than revenue. Congress introduced an excise duty on alcohol in 1791, and later the Washington administration levied taxes on snuff, sugar, carriages, and auction sales, while the administration of John Adams (1797–1801) taxed slaves, houses, and land to finance the Quasi War. President Thomas Jefferson (1801–1809) intensely disliked federal internal taxes and managed to eliminate them by his second
term. Nevertheless, a program of internal taxation far more ambitious than anything tried by the Federalists was launched by Republican president James Madison (1809–1817) to finance the War of 1812. Federal internal taxes are best known for provoking the Whiskey Rebellion in 1794 and Fries's Rebellion in 1799, but although these revolts certainly demonstrated the narrow confines of legitimate federal taxation in the early Republic—and how perilous it was to challenge them—they were of only limited significance in the general development of the American fiscal system.
In the states, Congress's requisitions and the charges on the public debt had been by far the greatest items of expenditure before the adoption of the Constitution. When the federal government assumed responsibility for the debt, these expenditures disappeared from the state budgets. As a result, direct state taxes were reduced by at least 75 percent. Because these were the taxes that had brought hardship in the 1780s, the Federalist reform in effect provided relief for the taxpayers. It also made conflicts over fiscal policy disappear from the agenda of state politics.
As state taxes fell and income from the federal impost grew, the federal government came to raise far more money than the states in both absolute and per capita terms. However, since the impost was collected directly from merchants, most ordinary taxpayers made no direct contribution to the federal government. At the same time, state taxes on persons and property continued to be low and state governments tried to raise revenue from other sources, such as taxes and fees on banks and income from investments. As a result, the American people were very lightly taxed in the four decades following the adoption of the Constitution.
On the expenditure side, payments on the public debt and appropriations for the military dominated the federal budget. There was little difference between Federalists and Republicans in this respect. Between 1789 and 1815, debt payments and support
|Per Capita Taxation, 5 Year Average, Current and 1840 Prices (dollars)|
of the army and navy accounted for almost 90 percent of total expenses. Foreign relations and the Indian Department accounted for roughly 4 percent of total expenses and the civil list and "miscellaneous" civil expenses for the remainder. In the final category, the central government apparatus accounted for more than half the costs. The only significant other "civilian" expenses were payments for lighthouses and buoys and pensions for invalids. By the late 1820s, however, the federal government had begun to make considerable outlays on internal improvements. The administration of John Quincy Adams (1825–1829) spent $2.1 million, more than 3 percent of total expenditures, on roads and canals.
In the states, the major expenditure items in the budgets from the 1790s and onward were the costs of executive, legislative, and judicial departments of government. Some states also spent considerable sums on education. In the late 1820s state governments, too, had begun to spend on internal improvements. However, the real boom in state-financed internal improvements began in earnest only in the 1830s.
The War for Independence was fought on credit and both the states and the federal government were heavily in debt when the war ended. In 1790 the collective state debt was estimated at $26 million, while the federal debt stood at $52 million. In the years immediately after the war, public creditors received different treatment in different states. Congress, however, was unable to honor the claims of both domestic and foreign federal creditors, with the sole exception of the investors in its Dutch loans. Congress defaulted on the debt owed to France and paid interest on its domestic debt in so-called indents or certificates of interest. Both federal securities and indents fell sharply in value in the 1780s. Since Congress paid neither principal nor interest in specie, the value of securities was determined by the likelihood that either the states or Congress would redeem them, or at least begin to pay interest in specie, at some future date. The securities had been issued as payment for services rendered and goods received during the war and had been given to a great number of soldiers and military suppliers. Most of these original holders did not possess the means to wait for a possible future redemption, but sold their securities to the highest bidder at prices far below face value. Over time, the debt was concentrated in fewer hands. According to one estimate, some fifteen thousand to twenty thousand people held securities in 1790.
The funding and assumption plans, which Hamilton presented to Congress in 1790, rapidly restored the value of securities. In a first move, the federal debt was "funded" on the British model. Old securities were exchanged for a new emission on which the government promised to pay interest in specie from the proceeds of earmarked taxes. While the government did not pledge to redeem the principal, securities could be sold on the market when a creditor needed specie. In a second move, the federal government assumed $18 million of state debt. In this way, the public debt was nationalized and the majority of the states became debt free. With a few exceptions, state borrowing did not become a factor in public finance again before the 1830s. In a final move, Congress created the Bank of the United States, which formed an integral part of the Federalists' system of public finance.
The Federalist program restored public credit, and from this time on the public debt was regarded as a near risk-free investment by Americans and foreigners alike. Yet the program was not universally endorsed. The opposition argued that securities appreciation would benefit the final and not the original holders and demanded that the government discriminate between final and original holders so as to benefit both equitably. Congress soundly defeated this
|Federal Revenue, Expenditure, and Indebtedness, Current and 1840 Prices|
|(millions of dollars)|
proposal because it would have jeopardized the restoration of public credit and thereby seriously restricted the ability of the federal government to raise new loans. The Republicans, however, continued to see the funding plan as a way to line the pockets of speculators with tax dollars, a view that modern historians largely share. The assumption of state debts also met with opposition. Assumption was proposed when Congress was still investigating the relative contribution of the states to the common war effort. Some members of Congress feared that assumption would lead to a premature settlement that would be disadvantageous to their states. In the end, it required the famous deal over the location of the new capital to enable the measure to gain Congressional approval. When the final settlement of accounts was reported in 1793, however, the issue died down. The chartering of the Bank of the United States was also controversial. Republicans deemed it unconstitutional and Congress refused to re-charter the bank when its twenty-year charter expired in 1811. Congress, with the support of President Madison and other leading Republicans, chartered the second Bank of the United States in 1816, but it suffered the same fate as its predecessor when Andrew Jackson used his presidential veto to prevent its re-charter in 1832.
The federal government made use of its ability to borrow money almost from its inception. New securities were issued to consolidate the foreign debt and to finance the naval and army buildup during the Quasi-War. Short-term loans from the Bank of the United States covered budget deficits and financed the expedition to quell the Whiskey Rebellion. However, despite their criticism of Federalist public finance, it was the Republicans who made the most use of loans. Jefferson purchased Louisiana in 1803 by issuing $11.25 million in securities that were eagerly picked up by British and Dutch investors on the Amsterdam market. Madison borrowed $82 million, mostly from domestic creditors, to prosecute the War of 1812. But if the Republicans borrowed more than the Federalists, they also redeemed the debt more rapidly. Because they saw the public debt as an evil, they used a long series of budget surpluses to reduce it. By 1829 the debt was down to $48.6 million. Five years later it was entirely paid off.
The fiscal and financial reforms carried out by the Federalists in the early 1790s had several important long-term consequences. First, while a fiscal system totally dependent on income from customs duties may have been popular with taxpayers, it was also very vulnerable to trade disruptions. English and French attacks on American trade during the Wars of the French Revolution and the Napoleonic Wars had direct repercussions for government income and public credit. Thus, if the new fiscal regime gave the federal government a certain independence from its taxpaying citizens, it made the nation vulnerable to the actions of European states. The attempts to deal with these powers dominated much of American politics up to 1815, from Jay's Treaty (1794) and the Quasi-War to Jefferson's Embargo (1807) and Madison's war with England.
Another important consequence of the Federalists' reforms was that the federal government became far stronger than it had been in the 1780s. In 1787 the American Republic was an impotent and bankrupt union of thirteen former colonies strung out along the Atlantic seaboard. Five decades later, it had conquered most of the North American continent. By the end of the nineteenth century, the American Empire extended to Asia. Sound public credit, backed by a regular revenue, was an important prerequisite for this development, whether it was used to raise money for territorial purchases or wars of conquest. In the struggle over North America, it is no coincidence that the two powers that emerged victorious—the United States and Great Britain—had the soundest public finances, while those that had to give way—France, Spain, and especially Mexico—all had considerable fiscal and financial difficulties.
The most important consequence of the reforms of the early 1790s was the creation of a financial system. In both the Netherlands and England, government borrowing had given rise to an active securities market that also allowed private enterprises to raise capital from investors. In the United States the same development occurred. The funding and assumption of the public debt gave rise to a rapid expansion of the securities market and the banking sector, which mobilized domestic and attracted foreign capital and made it available to entrepreneurs. Virtually every major economic activity in the early national period was financed by loans and bonds. In particular the large-scale investments in canals, turnpikes, bridges, and railways, which were so important in extending market expansion throughout the nation, would not have been possible without banks and a well-developed securities market. It may well be the case that the financial system created by the Constitution and the Federalists' policies was the primary cause of the spectacular growth of the American economy that had made these erstwhile colonies outgrow their former mother country by the time of the Civil War.
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