Electronic copy available at: http://ssrn.

com/abstract=2229053

DEPARTMENT OF
ECONOMI CS











Public Finance without Taxation:
Free-Riding as Institutional Artifact
Richard E. Wagner
George Mason University
Department of Economics
Working Paper No. 13-05
Electronic copy available at: http://ssrn.com/abstract=2229053
1

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


Richard E. Wagner


Department of Economics, 3G4
George Mason University
Fairfax, VA 22030, USA

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


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



Abstract

Expositions of the theory of public finance mostly wrongly assume that
taxation is necessary to finance public goods. Taxation isn't necessary to finance
public goods because free riding is an institutional artifact of the analytical
dichotomy between public and private goods, which prevents recognition of
social interaction through the institutions of civil society. Free riding is also
abetted through the particular institutional presumption that public goods must be
provided by collective entities that operate without alienable ownership. Free
riding is a product of a particular institutional arrangement and is not a universal
quality of societal living together. There is a deep similarity between cities and
such entities as hotels and malls which supply public goods without taxation.
Center stage in the theory of public finance can alternatively be occupied by the
social organization of shared consumption, with taxation relegated to side show
status.

Keywords: free riding; forced carrying; preference revelation; collective property
rights; 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, March
7-10, 2013]

Electronic copy available at: http://ssrn.com/abstract=2229053
2

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 Paul Samuelson's (1954,
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.
3

There have been, to be sure, some notable dissenters from the claim that
free riding prevents the supply of public goods through market-like arrangements.
Some illustrations of this dissent are Minasian (1964), Demsetz (1970), Coase
(1974), Brubaker (1975), Borcherding (1978), and Boudreaux and Holcombe
(1989). Furthermore, Buchanan (1968) sets forth a book-length examination of
how the supply of public goods might be incorporated into a framework of the
voluntary exchange theory of public finance (Musgrave 1939). Despite the
cogency of such analytical efforts, free riding and taxation still occupy center
stage in theories of public finance. Three types of reasons seem to explain the
continued ability of free riding and taxation to dominate the theoretical landscape
of public finance. One is conveyed by the welfare analytics of joint consumption,
wherein exclusion mechanisms violate the necessary conditions for Pareto
efficiency in the presence of Samuelson's equal consumption postulate. Another
reason is pragmatic relevance in the face of political power: taxation occupies
center stage not because it is the only way through which public goods can be
provided but because this is one method by which Power asserts its dominance,
and with the economics of economic theory generating accommodation with that
dominance (Wagner 2012a). A final reason, which will receive the most attention
here, is that the dominance of taxation is an artifact of the public-private
dichotomy in conjunction with the equilibrium-theoretic framework that supports
reduction of a society to a median voter who chooses within two institutional
settings, one of private goods exclusion and one of public goods non-exclusion.
This very analytical framework excludes from view a rich menu of institutional
4

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
that comprise what is commonly denoted as "civil society, which refers to
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
5

can facilitate or hinder the social organization of shared consumption (Radula
2010). In this regard, McCaleb and Wagner (1985) note that various experiments
on free riding show that free riding weakens as social interaction within the
experiment increases. Therein lays a key to recognition that free riding is an
institutional artifact and not a universal feature of societal living together in close
proximity.

1. Taxes and Public Pricing: Returning to Basics
The historical record shows numerous instances where public goods were
supplied through market-like arrangements. The cameralist period in central
Europe during the 15
th
through 18
th
centuries is one notable instance, as
Backhaus and Wagner (1987) and Wagner (2012c) explain. The cameralist
theory of public finance, represented crisply by Justi (1771), held that taxation
was but a secondary source of public finance. The primary source of revenue for
the supply of public goods came from various market-oriented activities
undertaken on behalf of the prince. The general cameralist presumption was that
princes could use their assets to generate the revenues that would finance
princely activities within their lands. Indeed, the quality of princely governance
was thought to vary inversely with the degree to which taxation was used. The
central conceptualization was that the prince acted largely as a participant within
the market, rather than acting parasitically on it by attaching taxes to market
transactions. Even late into the 19th century, revenues from commercial activity
were relatively far more significant in the formerly cameralist lands than in other
6

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 19
th
century, 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
(De Viti 1936), and with De Viti's approach to public pricing explored in Eusepi
and Wagner (2013). Central to De Viti's formulation was his treatment of a tax as
a form of pricing that was but one side of the transaction through which collective
activities were supplied. Within De Viti's vision of a cooperative state, a flat tax on
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
7

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
Viti's treatment of taxes as forms of public pricing, however, was not intended as
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
8

system of market prices and a system of political prices. For Pantaleoni, the
market prices were thought to equal marginal cost, in line with the theoretical
formulations of the time. In contrast, political prices were parasitical attachments
to market prices. Prices were generated through market transactions, and
political entities attached themselves to those prices. One form of political price is
a flat tax on income. It is market transactions that generate measures of income,
and political entities attach parasitically to those transactions instead of
generating prices through genuine market transactions. Political entities do not
generate revenue directly through the sale of services, but do so indirectly
through parasitical attachment to market entities.

2. Capitalizing Polities: Hotels, Malls, and City States
Hotels and malls provide apt illustrations of how public goods are provided
through market-based arrangements.
1
If we compare cities with hotels,
particularly relatively large ones that offer many services and amenities, we will
find little difference in the activities they pursue and the problems they face.
Hotels and malls are really cities within cities, containing both market-based and
collective-based activities. Within both cities and hotels, people individually
choose places to live, take meals, and buy clothing. They also are protected by
security services, ride on publicly provided transport, and have access to such
amenities as parks.

1
There is little formal difference between cities and hotels, as Spencer MacCallum (1970
explains and as Fred Foldvary (1994) amplifies. A city, moreover, represents the urban core of a
city-state, and with the city-state serving as an option to the nation state, as Hendrik Spruynt
(1994) explains.
9

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
10

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
11

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
12

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
13

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
deemed optimal in terms of the experiment's given conditions.
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
14

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.
15

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 employees, it doesn't so long as employers must attract employees
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
16

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
17

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.


18

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