II. PUBLIC FINANCE PRIOR TO THE 1940S

Prior to the Great Depression, the American Institutional tradition in public finance dominated theory and practice in the United States. Drawing heavily from the German continental thinkers in the Cameralist tradition, early practitioners such as Richard T. Ely and Henry C. Adams emphasized historical development, institutions, statistical data collection, and social policy engineering (Mehtrotra Reference Mehrotra, Nuetzenadel and Strupp2007; Ross Reference Ross1991). Edwin R. A. Seligman, the patriarch of American public finance, cast a long shadow over the field. Trained in Germany and by far the best-recognized scholar internationally, Seligman supervised roughly one-third of all dissertations in public finance in the US between 1900 and 1930,^{Footnote 1} and “considerably influenced the American opinion” (Simons Reference Simons1938, p. 16).

Although Seligman was not a card-carrying Institutionalist, his pluralistic methodology was fundamentally at odds with the formal-mathematical British school, whom he “chide[d] … for preferring formal proofs over practical reasoning, and … [whose] hypothetical conclusions when ‘applied to the conditions of the market-place … [were] likely to be unreal’” (Moss Reference Moss2003, p. 219).^{Footnote 2} Seligman was known for his use of practical, numerical examples, much to the dismay of Francis Y. Edgeworth, who felt such contrived expositions lacked theoretical and mathematical rigor. In turn, Seligman denigrated “the mathematical theory of taxation” and “took some pleasure in characterizing the Cournot–Edgeworth passion as a ‘school of thought’ that would produce mostly arcane theorems and generally useless esoterica” (Moss Reference Moss2003, p. 213). The Seligman–Edgeworth debate over tax incidence, which ran from 1892 to 1910, had lingering repercussions. Taking their tone from Seligman, American-Institutional economists emphasized applied methodologies, which included substantial historical-legal analyses, over mathematical modeling. Their viewpoint dominated public finance teaching at Columbia, California, Michigan, Wisconsin, and Yale, schools that produced more than half of the public finance PhDs prior to World War II (Johnson Reference Johnson2014). These same economists also actively engaged in social policy making at the federal and state levels and had an enormous influence on the design of the federal income tax and New Deal policies (Mehrotra Reference Mehrotra2014).

However, a fundamental shift in the field of economics occurred sometime between the late 1930s and the end of World War II. Departments stopped hiring Institutionalists; interwar pluralism was replaced by a growing neoclassical consensus, as evidenced by Tjalling Koopmans’s (Reference Koopmans1947) attack on Institutionalism as “measurement without theory” (Rutherford Reference Rutherford2011). As throughout the field, formalism and mathematical modeling began to overtake Institutional methodologies in public finance. This trend was accelerated by the decline in continental public finance engendered by the rise of Nazi Germany and its subsequent disastrous impact on the continental universities and European intellectualism (Backhaus and Wagner Reference Backhaus and Wagner2005). By 1945, the British-neoclassical approach reigned supreme in most US graduate programs. Best characterized by the contributions of Edgeworth and Arthur Cecil Pigou, the focus was on debt financing, tax design, and tax incidence. A review of standard textbooks of this period illustrates the dominance of the British viewpoint; little attention was given to the continental scholars, particularly the German and Italian contributors, even in programs with strong institutional viewpoints such as Wisconsin (see, for example, Groves Reference Groves1939).

By the time Buchanan enrolled at Chicago in the mid-1940s, a new vanguard of public finance economists had begun to emerge. Harold Groves published his textbook Financing Government (1939), which, though decidedly more Seligman than Edgeworth, represented a significant shift in the Institutionalist approach to economic modeling and public finance. It also laid out Wisconsin-Institutionalist thinking on the New Deal, tax reform, and war financing. At Columbia, Carl Shoup published his Facing the Tax Problem (1937). Richard Musgrave was nearly ten years into his notable career, actively working to transform public finance “from a descriptive and institutional subject to one that used the tools of microeconomics and Keynesian macroeconomics to understand the effect of taxes” (Walsh Reference Walsh2007, online).

III. PUBLIC FINANCE AT CHICAGO

The confusion that arises periodically about Buchanan’s dissertation adviser provides a starting point to explore public finance at Chicago in the immediate post-war period. Buchanan’s dissertation in the University of Chicago library contains neither a signature page nor acknowledgments;^{Footnote 3} this absence contributes to the mistaken idea that Knight served as his dissertation advisor (see, for example, Meadowcroft Reference Meadowcroft2011, p. 15).^{Footnote 4} Buchanan’s actual dissertation supervisor was Roy Blough, confirmed by the Department of Economics at the University of Chicago, which states the “Permanent Thesis Committee was announced in a memo to the faculty to be R. Blough as the chair with H. Perloff and F. H. Knight on his Thesis Committee. Also the faculty listed in attendance at his Thesis Defense were the following: Schultz, T. W.; Knight, F. H; Mints, L. W.; Burns, R; Lewis, H. G.; Cooper; Goode, R.” (Less Reference Less2012).^{Footnote 5} However, Buchanan found Blough unhelpful during the writing of the dissertation and relied much more heavily on Knight, whose fingerprints are evident throughout. In fact, the Henry Simons–Knightian intellectual legacy that was to define aspects of Chicago economics was much in evidence at Buchanan’s defense, with Simons’s self-identified libertarian faction making up most of the committee and attendees.^{Footnote 6}

Buchanan enrolled at the University of Chicago in the winter quarter of 1946, chosen on the recommendation of a former professor, though he states that “had I known the ideological character of the Chicago faculty I might have chosen to go elsewhere” (1992, p. 4). What Buchanan never tells us is why he was drawn to public finance in the first place.^{Footnote 7} Neither his description of his self-identified formative experiences at Chicago—Knight’s price theory course—nor his mention of his discovery of Knut Wicksell’s Finanztheoretische Untersuchungen (1896) shed any light on this. The latter, while topically relevant, is said to have occurred in the summer of 1948 (Buchanan Reference Buchanan2007, p. 5), well after Buchanan had chosen his primary field and begun his dissertation.

What makes the choice of public finance more intriguing is that in 1946, Chicago public finance was in a state of upheaval. Simeon E. Leland, who had been teaching Government Finance (EC 360), State and Local Taxation (EC 362), and Public Debts (EC 367), left Chicago after the spring quarter to become the dean of the College of Liberal Arts at Northwestern University. Simons, who, for more than a decade, had taught Economics of Fiscal Policy (EC 361) and Government Finance (EC 360), died in June. Blough was hired for the fall quarter with a joint appointment in economics and political science; he took over the graduate teaching duties for public finance through 1950, with some assistance by Richard Goode, who joined Chicago in the fall of 1947 (University of Chicago Annual Register 1946–47, p. 219). Public finance was a microcosm of the department, which was itself in a state of foment with the departure of Jacob Viner and the arrival of Milton Friedman.

In his first quarter of studies, Buchanan enrolled in Knight’s price theory course, State and Local Taxation with Leland, and a third course taught by Theodore William Schultz (Buchanan Reference Buchanan2007, p. 70; University of Chicago Annual Register 1945–46, p. 224). Leland had completed his dissertation on “The Classified Property Tax in the United States” at Chicago in 1926, quite possibly under Jacob Viner, who was teaching graduate public finance at the time. Leland was a central member of the New Deal group at Chicago in the 1930s and had largely institutional leanings (Brady Reference Brady and Emmett2007; Van Overtveldt Reference Van Overveldt2007). An expert in the problems of the coordination of fiscal units in a federalist system, Leland was deeply interested in institutional structures and advocated for the complete integration of federal, state, and local revenue systems, a proposal that would make states mere administrative areas (Leland Reference Leland1930). Leland’s view of government was distinctly at odds with that of Simons, who felt that the federal government should focus on “legislation … [that] follows clear, announced rules of policy,” whereas states should focus on the provision of social and governmental services (Simons Reference Simons1948, p. 18). Buchanan chose to write in Leland’s area of expertise and produced a dissertation on fostering fiscal equity in a federalist system. In his dissertation, Buchanan (Reference Buchanan1948) argued in favor of a system based on states’ rights and revenue sharing. Though his own views on federalism were quite different, Buchanan found Leland a very competent scholar and felt that Leland’s position of complete integration of the fiscal system “has a great deal to recommend it … it contains many advantages over the numerous confused ‘compromise’ solutions” (1948, p. 144; see also Buchanan Reference Buchanan1950, p. 585n7).

Leland’s teaching was strictly in the British neoclassical tradition. Describing his coursework, Buchanan stated:

In the spring quarter of 1946, Buchanan enrolled in Simons’s Economics of Fiscal Policy, and it was thanks to “the instruction of Frank Knight and Henry Simons, my Chicago teachers, [that] I was forced to fully absorb the simple principles of market allocation” (Buchanan Reference Buchanan2007, p. 216).^{Footnote 8} Simons, too, adhered to the classical British tradition in public finance, finding it “intellectually respectable” (Samuels Reference Samuels2005, p. 255; see also 1937b), compared to Seligman’s work, which consisted of a “procession of sophomoric generalizations which corrupt the student’s understanding of economic theory and plague the teacher” (Simons Reference Simons1937a, p. 532).

During Buchanan’s time at Chicago, public finance was not a major research interest, and coursework more often resembled a trade school for tax-policy writing than the intellectually stimulating environment that Buchanan sought when he matriculated. Although public finance held a strong position in terms of the number of teaching faculty, this can be primarily attributed to historical legacy rather than to an active research program.^{Footnote 9} Public finance was one of the earliest economics subfields taught in the United States, and, hence, existed at Chicago from its establishment. The subfield gained early prominence in the department, thanks to an impressive series of scholars, including Adolph Miller, Henry C. Adams, and Harold Millis (Johnson Reference Johnson2014). However, by the 1940s, it was a different story; Chicago was turning out relatively few specialists in public finance, despite graduating the third-most PhDs in economics (Froman Reference Froman1942, Reference Froman1952). Leland had become decidedly less active in advising graduate students and publishing. Blough was a temporary fix, and public finance essentially disappeared after his departure until Arnold Harberger resurrected the field in the early to mid-1950s. During Buchanan’s residence, public finance was further distanced from the center of departmental activity, as key professors held joint appointments in other areas—Leland and Blough both in political science and Simons in the law school.

The most active of the faculty in the 1940s, Simons made notable contributions to public finance theory, including what has come to be known as the Haig–Simons definition of income, which underlies our modern income tax.^{Footnote 10} Simons stressed the importance of definitions of income and accounting, arguing that “every bit of measurement of income is a construction” and cautioning that “such rules of thumb are soon elevated into principles” (Samuels Reference Samuels2005, p. 252). His clear definitions and careful thinking about tax policy made his Personal Income Taxation (1938) a field standard that continues to have influence. Simons’s primary complaint of public finance was its purported scientism. Simons argued that practitioners ought to identify the social objectives of economic policy and design tax policy to achieve those ends (1938, p. 2). Sometimes characterized as not wholly in line with the Chicago tradition due to his views on patents, anti-trust, and progressive taxation, Simons recognized there was no free lunch. Public finance was, by construction, the study of intervention in the economic order; for Simons, practicing public finance meant designing better tools to achieve pre-agreed-upon social objectives. Simons did adhere to the standard Chicago storyline that taxes necessarily result in a less efficient use of resources (Samuels Reference Samuels2005; see also Buchanan Reference Buchanan2010). It is telling that most of Simons’s analyses of taxes weighed efficiency concerns between competing taxes, replacing one tax with a revenue-neutral equivalent. Simons did not consider expenditures as a relevant part of the story.

Simons’s views remained manifest in Chicago public finance courses for many years following his death. Blough continued to assign Personal Income Taxation (1938) along with several additional writings by Simons in graduate public finance courses. This meant that the intellectual heritage that Simons (Reference Simons1938) identified in Viner, Knight, Leland, Shoup, and Director was reproduced for the following generation of students. Blough’s course notes also evidence significant discussion of Simons’s work—to the extent that one wonders if Blough inherited Simons’s lecture notes along with his teaching responsibilities (Course Notes from Blough’s Fiscal Policy and Taxation, EC 361, Norman Maurice Kaplan Papers, Box 1, Folder 5).

Blough joined the Chicago faculty as an undeniable expert in tax policy. His primary research interest, developed at the US Treasury, was the implementation of the federal income tax. A Wisconsin PhD (1929), Blough moved in and out of government and university positions prior to coming to Chicago.^{Footnote 11} At the treasury, Blough was agnostic to the great methodological debates going on in public finance; he regularly sought feedback from Simons in addition to Groves, Shoup, Musgrave, and Paul Samuelson. He also frequently hosted the same economists for workshops on applied tax questions (see the letters between Blough and Simons, Henry C. Simons Papers, Series I, Box 1, Folder 43). Blough was a technocrat, with a strong interest in tax design, rather than theory; Simons, however, generally held Blough’s work in high esteem (Simons Reference Simons1937a).

Blough (Reference Blough1944) laid out his views on the theoretical underpinnings and motivations for tax policy; it is here that Blough’s Institutional background is most evident, particularly his conceptualization of taxation as conflict between competing political groups. “Taxation is no passive instrument.… The potency of taxation is so great that it may be and indeed is continually used as an instrument for making changes which the politically dominant groups believe should be made in the social structure” (Blough Reference Blough1944, p. 22). Blough saw tax policy as part of a larger social science, and argued that one needed to view taxes as part distribution, part economic, part political, and part practical. To understand a tax system required a systematic analysis that recognized the “basic conflicts … that make the problem of tax policy one of choice among competing and frequently antagonistic interests” (Blough Reference Blough1937, p. 547).^{Footnote 12} The ideas of harmony and conflict play an important role in Blough’s evaluation of tax policy. Conflict is the “situation where one person’s gain is another person’s loss, while harmony is a situation where one person’s gain may also be another person’s gain, with no one the loser” (1944, p. 23). This is not unlike Buchanan’s later conceptualization of the equivalence between unanimity rule and Pareto optimality in public choice.

For Blough, the central conflicts of taxation have their roots in the disconnect between what one pays in taxes and what one receives in benefits, “because in taxation there is little or no relation between the amount of taxes a person pays and the amount of benefits he may derive from Government” (1944, p. 23). This disjoint was a legacy of the Progressive movement’s advocacy for a national progressive income tax. The ultimate passage of the 16th Amendment authorizing a federal income tax had required a substantial shift in professional and public opinion, moving from a benefit’s based approach to taxation to ability-to-pay. A by-product of this monumental shift in thinking was the severing of expenditures from revenues in economic analysis (Mehrotra Reference Mehrotra2014), something Buchanan recognized and lamented.

IV. WHAT BUCHANAN REALLY LEARNED AT CHICAGO

V. BREAKING NEW GROUND

Buchanan sought to integrate neoclassical public finance with the “distinctive features of Chicago economics” propagated by Knight and Viner, and identified by Simons to include “its traditional–liberal political philosophy—its emphasis on the virtues of dispersion of economic power (free markets) and of political decentralization” (in van Horn and Mirowski Reference Van Horn, Mirowski, Mirowski and Plehwe2009). Following Leland’s (Reference Leland1930) work on the integration of fiscal systems at different levels of government, Buchanan (Reference Buchanan1948, Reference Buchanan1950, Reference Buchanan1952a) addressed the fiscal problem of federalism. Buchanan wanted to counter the increasing centralization of tax policy goals and design, arguing that the same objectives could be achieved in a more federalist system. Buchanan’s concern was that without strategies to equalize fiscal burdens across states, “the laissez faire result will be the ultimate centralization of a large share of effective political power” (1950, p. 599). Both papers generated sufficient response in the literature that Buchanan felt it necessary to clarify his positions (1951b and 1952c); in the latter, he defined himself as following the tradition of Knight (1952c, p. 538).

Despite success practicing orthodox public finance, Buchanan was dissatisfied with an approach that, following British neoclassical models, represented government as a monolithic, benevolent structure. Rather, he argued that institutions and rules matter, something appreciated by both Knight and Simons, and, for Buchanan, a defining feature of the “old” Chicago school (2010, p. 4). Taking as his starting point Simons (Reference Simons1938) and Knight (Reference Knight1924), Buchanan sought to shift the emphasis from a regulatory role for government in resolving problems in public finance to one that separated the rules from the playing of the game, since “a major source of confusion … stems from the failure to distinguish carefully between the selection of the power structure among individual choosers and the selection of the choice mechanism” (Buchanan Reference Buchanan1954, p. 342). In his dissertation, Buchanan argued that you must accept one of two tenets. Either you believe that an economic problem can “best be solved by a competitive free enterprise system operating within the limits of defined ‘rules of the game,’” or you accept the basic tenet of the opposing school, “asserting that a freely competitive system is not the ultimate means and that instead greater political direction of economic life is required for the optimum solution of the economic problem” (1948, pp. 6–7). From these tenets followed two ways to think about government: models that represented government as “organistic,” where the government acted as a decision-making unit relaying on a concept of social welfare; and “individualistic” models, where individuals form the basis of theories of government and are the appropriate decision-making units (Buchanan Reference Buchanan1949).

Following Knight, Buchanan wanted a mechanism by which the features of exchange in the market could be applied to individuals’ exchanges with government, where freedom to choose to engage in such exchanges was a paramount feature. This ran counter to most models that viewed the individual–government relationship necessarily as one of coercion (e.g., Musgrave Reference Musgrave1939) and that rejected voluntary exchange as “altogether unrealistic” (Musgrave Reference Musgrave1941, p. 322). Buchanan argued that “vague and general terms, such as ‘social utility’ and ‘social welfare,’ are of little use in the discussion of policy problems” (1949, p. 498) and, instead, carefully distinguished between policies approved through the fiscal mechanism, which would be subject to the political caprices of the current government, and policies approved under the unanimity rule. Only the latter could ensure that all expenditures undertaken were “genuinely beneficial” when evaluated on a quid quo pro individual basis (1952b, p. 601; see also 1951a).

The logical extension of the quid pro quo was that economists needed to consider governmental expenditures, not only tax revenues. Simons, in particular, gave little purchase to expenditures, which were “not of much interest to the economist” (Samuels Reference Samuels2005, p. 245). Simons held that progressive income taxation would achieve the roughly 10% of national income required to fund the federal government, and would also “provide the necessary discipline by means of which the kind and amount of central government activity can be determined properly” (Simons Reference Simons1950, p. vii). He had nothing to contribute to the allocation of funding between competing governmental activities.

Buchanan’s brilliant jump early in his career was to envision how to integrate a theory of expenditures into Chicago thinking. This foresight would become extremely important in shaping the development of public choice, where “both the level of tax burden and the range of publicly provided services must be included” (Buchanan Reference Buchanan1950, p. 586). Buchanan argued:

The “point seemed so simple, indeed obvious, yet so locked in was the utilitarian mindset of orthodox public finance that the article was widely cited as seminal” (Buchanan Reference Buchanan2007, p. 6). Buchanan was particularly concerned by the centralization of government at the federal level that had occurred throughout the previous decades, and argued that “those who desire to see maintained a truly decentralized political structure in the power sense, must take some action” (Buchanan Reference Buchanan1950, p. 599).

To incorporate expenditures into the decision making, Buchanan adopted Wicksell’s voluntary exchange model as his historical antecedent. Buchanan explained that Wicksell’s unanimity rule for public goods works because it makes explicit each individual’s costs and benefits from a particular expenditure-tax proposal. This is necessary since voluntary participation in the political system requires that the costs imposed be offset by the benefits received. A rational individual will engage in a trade with government when he receives more in benefit than is paid in costs—quid pro quo (Buchanan Reference Buchanan1949). Orthodox neoclassical public finance, including that practiced at Chicago, adhered to the division that expenditures providing identifiable and special benefits should fall under the benefit principle of taxation, whereas expenditures that yield hard-to-quantify, general societal benefits, be funded by ability to pay (1952b). Most governmental expenditures fell into the latter category. Thus, Buchanan’s position ran counter to more than sixty years of conventional wisdom in public finance that had shifted the field from predominantly benefit to predominantly ability to pay (see, for example, Musgrave Reference Musgrave1939; Groves Reference Groves1939). This shift severed the direct link between the individual and the government, something Ajay Mehtrotra (Reference Mehrotra2014) argued was necessary to secure the adoption of a progressive federal income tax. Combined with the massive institutional changes in the federal government due to New Deal policies and the financing of World War II, Buchanan was swimming against the tide, even at Chicago. Simons had rejected the benefit principle as “leading nowhere” (1938, pp. 190–198), and Blough claimed that “the benefits which the individual receives from government do not depend on the amount he pays. So far as he is concerned the two are unrelated” (1944, pp. 13–14). However, despite the numerous objections, Buchanan argued that it did not follow that the theory should be “categorically rejected … the basis of the whole approach is theoretically sound and cannot be refuted” (1948, p. 39).

Buchanan was interested in policy beyond a criterion of efficiency in resource allocation —that society has other considerations, including inequality and issues of the “proper use of the ‘fisc’ which cannot and should not be summarily passed over” (1952a, p. 217). Much like Knight, who argued that appreciation of the democratic process and social values such as freedom, justice, and equality was necessary to make public policy in a democratic society (Emmett Reference Emmett2009), Buchanan, too, saw economics more broadly. In this sense, Buchanan’s early work can be understood in the context of his search for a market-analogous, competitive model for government behavior.