A.C. Pigou on Supply, Demand and Taxation

Mason Gaffney

[Comments by Professor Gaffney on the Mongiovi-Lee-Colander dialogue,
conveyed in an email dated 16 March, 2008]

In this connection, I suggest another look at Charles Ramsey's work, guided by A.C. Pigou, on supply, demand, and taxation.

A.C. Pigou (orig. 1928) A Study in Public Finance. [3rd Ed., 1947, rpt. 1949. London: Macmillan & Co. Ltd.], writes as follows:

pp.105-09 on the Ramsey rule. "by analogous reasoning it can be shown that, when one source of production yields an absolutely inelastic supply, ... a given revenue can be raised with less sacrifice by concentrating taxation upon this use than by imposing uniform rates of tax on all uses." - p105

p.108, "if there is any commodity for which either the demand or the supply is absolutely inelastic, the formula implies that the rate of tax imposed on every other commodity must be nil, i.e. that the whole of the revenue wanted must be raised on that commodity."

That looks a lot like Henry George, cautiously laid between the lines timidly and obliquely.

Several texts I have consulted explain the Ramsey Rule solely in terms of demand, not mentioning supply. However, Pigou is the most authoritative source on Ramsey, other than Ramsey himself. Ramsey was his protege; they worked closely together, and Pigou's book was published just a year following Ramsey's article.

So, in this case it looks as though Neoclassical economics consisted of reshaping a classically inspired text to "change the emphasis from big questions to price-of-eggs questions", as that wonderful Mrs. Robinson said.

Allyn Young, 1929, got Pigou's and Ramsey's point all right [Review of A.C. Pigou: a Study in Public Finance, 1928. EJ XXXIX, March. Rpt in Musgrave & Peacock, Readings in the Economics of Taxation, 1959 (Irwin) pp.13-18]

P.15, Young quotes Pigou, rates should "become progressively higher as we pass from uses of very elastic demand OR SUPPLY (emphasis mine) to uses where demand OR SUPPLY (emphasis mine) are progressively less elastic."

More recently, I find only one source that is true to Ramsey and Pigou: Joseph Stiglitz, 1986, Economics of the Public Sector, (NY & London: W.W. Norton):

P.404, "Ramsey taxes are proportional to the sum of the reciprocal of the elasticity of demand AND SUPPLY: (emphasis mine)"

He puts this in the form of a simple equation (also found in Pigou, p.108, evidently taken directly from Ramsey).

NOTE THAT IF THE ELASTICITY OF SUPPLY (OR DEMAND) IS ZERO, TAX RATES MAY BE AS HIGH AS YOU PLEASE.

In practical terms, what does this mean? There is no commodity for which the demand is inelastic for all possible prices. For most items, this is obvious at all prices. Suppose, though, there is something so essential, and buyers so obsessive (like serious drug addicts), that they are frantic to get the item "at any price." Is this then a source of infinite tax revenues? No, because if you raise the tax-price high enough, buyers will run out of money. Think compensated demand curves.

With supply, it is another story. The supply of land is absolutely inelastic, at any price. The Ramsey Rule, therefore, tells us plainly that, to repeat Pigou:

"When one source of production yields an absolutely inelastic supply, ... A given revenue can be raised with less sacrifice by concentrating taxation upon this use than by imposing uniform rates of tax on all uses."

"... if there is any commodity for which ... the supply is absolutely inelastic, the formula implies that the rate of tax imposed on every other commodity must be nil, i.e. that the whole of the revenue wanted must be raised on that commodity." -pp.105, 108.

And yet, most modern texts on public finance explain the Ramsey Rule solely in terms of demand, not even mentioning supply. How can we explain such a curious flight from the source, and from reality? Some, alas, are just copying from each other, but it had to start someplace. Are these writers simply not ready to face the Georgist implications of the Ramsey Rule? Is that attitude a component of Neo-classical economics? It was assuredly central to the thinking of J.B. Clark, who focused the first half or more of his career on attacking Henry George, as documented in Gaffney, "Neo-classical Economics as a Stratagem".