The Social Contract
Once upon a time in a faraway land there lived a people in a state of nature. There were no laws to tell them
what they couldn't do, no police to order them around, and no government to make them pay taxes. You might
think it was heaven on earth. But, alas, it wasn't.
Each spring the Earnest family planted crops and each fall they harvested them. But each winter the Bully
family ate most of the crops, while the Earnest family had barely enough crops to survive. How did this
happen? Very simply. Each fall, just as the Earnests finished harvesting their crops, they were paid a visit by the
Bully family.
"Here come the Bullys again!" cried the littlest Earnest, pointing out the window of their small cottage. In a
few seconds the door flung open and in came the Bullys. They were big, they were mean, and there were plenty
of them. "Where's the crop?" growled Big Bully himself. Trembling, the Earnests pointed to their modest barn.
Soon every Bully was carrying the stored corn to the Bully wagon. In a half hour they had loaded up nearly all
the crop. Suddenly the door was flung open again. It was Nasty Bully herself.
"Quit shaking and whimpering," she said with contempt. "We left you just enough to make it through the
winter. After all, if you starved, who would slave for us next year?" Then she turned and cackled uproariously
until she got to the huge Bully wagon. In a few seconds, the Bully wagon was gone, and so was most of the
Earnest crop.
"It's not fair," cried the littlest Earnest.
"Can't we do something about it?" asked Mother Earnest.
"Not by ourselves," said Father Earnest. "The Bullys are too strong." "But we can get help," said Mother Earnest. "We're not the only ones the Bullys pick on. They do the same
thing to other families. They take tools from the Smiths, clothes from the Weavers, and a huge volume of
products from the energetic Productives. They ignore the Lazys, who don't produce anything, but they take most
of the meager output of the Tryers, who work long and hard but are able to produce very little."
"Let's call a secret meeting of all the families the Bullys prey on," said Father Earnest. "I think I know how we
can solve our Bully problem."
Our Government
In the dead of night, while the Bullys slept soundly, the families walked silently through a moonlit field,
traversed a dark woods, and finally emerged into a clearing. They lit a fire and sat near its warmth.
"I've called this meeting, " began Father Earnest, "because our state of nature just isn't working. The Bullys
take advantage of all of us. It's time we did something about it' "
"What can we do?" whispered Timidas.
"We need to protect what we produce" replied Earnest. "I propose that each family contribute one member- a strong one- to a new organization. It will be called the police. Its mission will be to protect everyone from the Bullys."
"The police will need weapons," said Productive. "The Smiths make weapons. They can make them and give
them to our police.
"The members of the Fair family shifted uneasily. Finally Father Fair spoke up. "We don't think the whole burden should be put on the Smiths just because they make weapons. We should all share the burden.
"Economas interjected, "That's easy enough. Let the Smiths make the weapons. Since every household, except
the Lazys, earns coins selling what it produces, each household can contribute some coins to the police. The
police will use some of the coins to buy weapons from the Smiths, and will use the rest of the coins to buy the
food and clothes they need.
"Suspicious spoke up. "But how do we make sure the police don't violate our rights while they track down
Bullys?"
Politicas replied, "We need courts and judges to protect us from our own police, as well as to decide our
disputes peacefully, and make sure only the guilty go to jail, while the innocent go free. We will need some
taxes to pay the judges."
Next Mother Fair asked, "How do we make sure that everyone contributes coins, and how do we decide how
much each household should contribute?"
Politicas replied, "We need to form a government. We must remember that it is our government, created by
us, to do our bidding. It is up to us to decide what our government can and cannot do. Of course, it is impractical
to have our government make decisions by calling meetings where every family participates. We're all too busy
for that. Instead, we should vote to elect representatives who will meet regularly and make decisions. We know
the first thing we want our representatives to do: hire and supervise the police, decide how much tax each
household must pay, and make sure that every household pays its assigned tax. If they do a poor job, we'll replace
them in the next election."
"Much as I hate to admit it said Libertas, "we must give our government the power to do these things, "
Everyone nodded in agreement.
And so, within in a few days, the first election was held, a government formed, police chosen, and taxes
collected. The next time the Bullys came to someone's house, they were shocked. Before they knew what had hit
them, they were in handcuffs, riding in the new police wagon to the new jail.
Things were fine for a while, but one day the littlest Earnest climbed to the highest mountain peak in the land,
looked out in the distance, squinted, and then climbed down the mountain as fast as he could and ran home
shouting, "Foreign Bullys, foreign Bullys! I saw them, I saw them!"
"Tell us what you saw," said Mother Earnest, trying to calm him down.
"Far in the distance, I saw people with weapons, and horses, and big wagons. They looked just like our Bullys."
"Were they riding toward us?" asked Mother Earnest.
"Not yet," he replied. "But they could. And if they do, we'll be in big trouble."
Mother Earnest called a meeting that very night. And everyone agreed that the police could not handle an
invasion by foreign Bullys. Moreover, they realized they were in great danger from foreign Bullys, because
word might have spread that their own Bullys were no longer in control. Defensas said, "I propose we
immediately create a military, far stronger than our police, to protect us against invasion by foreign Bullys."
"This will require a lot more taxes than we needed for the police," said Father Earnest.
"We have no choice," replied Defensas. "Our victory over our own Bullys will mean little if we are conquered
by foreign Bullys.
"And so it was agreed. Much higher taxes were raised, and a strong military was established. A message about
the new military was sent to foreign lands.
A month later, the littlest Earnest climbed the same mountain and stared out in the distance in all directions.
No matter how hard he looked, he saw no signs of anyone approaching with weapons, horses, and wagons.
"They must have heard about out new military," he said with a proud smile.
The Free Market
Exactly one year later, the citizens met on a moonlit night in the very same clearing to celebrate the first
anniversary of their new government and to assess its impact.
Productive spoke first. "Things are great. With the Bullys behind bars, my family has the skill and energy to
invent and produce things people need, so this year we earned a huge volume of coins. All we want our
government to do is to keep our own Bullys out of our way and prevent foreign Bullys from causing trouble.
"Immediately Socialas stood up. "I couldn't disagree with you more, Productive. Now that we have formed a
government, we should use it to its maximum potential. Today, every family makes its own decision about what
and how much to produce. There is no central coordination and planning to make sure there is enough of good X
but not too much of good Y. Every family pursues its own self-interest, trying to make as much profit as it can,
without thinking about the needs of our whole society."
"What should we do?" asked Naivas.
"I propose," continued Socialas, "that the government coordinate and plan our economy. The government
should draw up a detailed economic plan specifying how much of goods X, Y, and Z should be produced. Then
the government should employ each family, and assign each one a specific productive task to make sure that the
plan is carried out. If we don't do this, we'll have chaos."
An uneasiness came over the people. On one hand,
most cherished the freedom to decide on their own economic activity without government orders. But on the
other hand, Socialas's point seemed plausible. Wouldn't there be chaos unless the government specified the
required amounts of goods X, Y, and Z and employed every family to make sure the required amounts were
produced?
At this very moment, the most brilliant member of the Smith family, Adam, rose to his feet. In his hand he
held a lengthy manuscript. "I rise to answer Socialas," Adam Smith said calmly. "But have no fear," he soothed
the crowd. "I will not attempt to read this manuscript to you. I have just completed it after several years of work.
It's called The Wealth of Nations, and I hope that some of you will find the time and interest to read it. Tonight, I
will briefly summarize it in order to answer Socialas.
"The people looked at Adam Smith with anticipation. He was not merely the most brilliant member of his
family. Many felt he was the most brilliant person in their entire society. Then Smith began to speak.
"Each family is now free to decide what and how much to produce, and with the Bullys removed, each knows
that if it produces more, it will consume more. Each is free to pursue its own economic self-interest. You all
appreciate that freedom. But many of you worry that Socialas is right, that the result will be chaos. I want to
assure you, this evening, that your fears are unfounded."
"By forming a government to protect us from the Bullys," Smith continued, "a remarkable system has come
into being: the free market. Socialas says that chaos will result, but let me begin with this question: Has there
been chaos this year?"
"Not really," said Earnest. "In fact, the economy has worked very well. All the families, except the Lazys,
have been working hard to produce high-quality products at the lowest possible cost, and consumers seem
pleased."
"But:' asked Smith, "why do producers care about high quality and low cost? Aren't they concerned mainly
about their own profit?"
"Yes," replied Earnest, "every producer strives to make a profit. I must confess that our family cares about
profit too."
"Yet you say consumers seem pleased. Now, how can this be?" Smith asked with a twinkle in his eye.
"I'm not sure," replied Earnest. "Let me ask you a question, said smith. "How does your family decide what and how much to produce in
order to make a profit?"
"Well" said Earnest, "first we think about what we're best at making. We're best at growing crops. We know
we shouldn't try to make clothes or tools. The Weavers are much better at making clothes, and the Smith family
except for you, Adam is much better at making tools."
"Yes" said Adam, "I have disappointed my family by teaching and writing instead of making tools. They are
particularly upset about the subject I have chosen: economics. They say I have disgraced them by becoming an economist. But I'm hopeful that my book, The Wealth. qf Nations, will prove to be a different kind
of powerful tool, worthy of Smith. History will judge. But let's get back to your family, Earnest.How do you decide which crops will be the most profitable?"
"We see that consumers like corn better than stinkus. If we grow corn, we make a profit. If we grow stinkus,
we don't."
"And why do you work hard to produce your crop at lowest possible cost?" asked Smith.
"Because we have to charge a price that covers our cost. A low cost lets us charge a low price."
"I suspect," interjected Socialas, "that you want to charge a high price even if your cost is low, so you can
make a huge profit. "
"I confess," said Earnest, "that you're right about what we want. But we can't do it."
"Why not?" asked Socialas. "Does your conscience stop you?"
"No, its not our conscience," replied Earnest. "It's our competition."
"I don't follow," said Socialas.
"Well," said Earnest, "we're not the only family growing corn. A dozen families grow corn. If we charge a
price much above cost, they'll offer consumers a lower price, and no one will buy com from us."
"I suspect," interjected Socialas, "that you want to grow low-quality corn because it's cheaper." "Once again," said Earnest,
"I confess," said Earnest, "that you're right about what we want.
But we can't do it."
"Why not?" asked Socialas. "Does your conscience stop you?"
"No, its not
our conscience," replied Earnest. "It's our competition."
"I don't lollow," said Socialas
"Well", said Earnest, "we're not the only family growing corn. A sozen families grow corn. If we charge a price muchavbove cost, theyill offer consumers a lower price, and no one will buy corn from us."
"I suspect," injected Socialas, "that you want to grow low-quality corn because it's cheaper."
"Once again," said Earnest, "I confess the you're right about what we want, buyt we can't do it, not because our conscience, but because ou our competition.
Most consumers are willing to pay a higher price for high-quality corn. We actually make more profit producing high-quality corn, even though the higher cost makes us
charge a higher price."
"And so," said Adam Smith, "you make a profit by figuring out what consumers want, and producing it for
them. Competition prevents you from over-charging and compels you to produce a high quality with the lowest
possible cost."
"That's true," said Earnest.
"But," said Socialas, "he admits that his family and all the others are pursuing their own self-interest. No one
is making sure that their decisions serve the public interest."
"Socialas," replied Adam Smith with a smile, "they are indeed freely pursuing their own interest, and no
earthly government is telling them what or how much to produce. But in a free market they are led by an
invisible hand to make decisions and pursue economic activities that serve the public interest.
"The people nodded their agreement with Adam Smith, and Socialas sat down, dejected.
Social Insurance
As Socialas sat down, Father Fair stood up to speak. "Adam Smith has brilliantly shown us the virtues of a free
market. Except Socialas, we are all convinced that our government should not employ families to make goods
X, Y, and Z, or interfere with each family's decisions about what and how much to produce. But though we have
rejected Socialas's radical role for the government, we must still ask whether there is a more limited role our
government should perform as a complement to the free market.
"Productive replied, "All we want our government to do is to keep our own Bullys out of our way and prevent
foreign Bullys from causing trouble.
"Father Fair replied, "I believe there is something else we should instruct our government to do. It's great that
the Bullys are behind bars and that the Productives can produce as much as they can without fear it will be
stolen.
We all benefit from their skill and energy. But not everyone has as much skill and energy as the Productives.
I'm not concerned about the Lazys- at least not the grown-ups. They simply don't want to work, they earn
nothing,
and it's certainly fair that they consume very little, surviving on the few coins they receive from Charitas."
"But," continued Father Fair, "I am concerried about the Tryers. They work as long and as hard as the
Productives, but they produce so much less. No matter how hard they try, they barely earn enough to survive. They need supervision, so they work for the Productives, who assign them tasks and pay them according to
what they produce. You can't blame the Productives for paying them a low wage because the Tryers produce a small amount, but the low wage means they can't afford to save anything. You can't blame the Productives for laying
them off when sales are slow. And when Tryers get too old to work, or need costly medical care, they're in
trouble. Only the, generosity of Charitas keeps the Tryers from starving when they're unemployed or too old to
work, and gets them essential medical care. But Charitas is getting old, and soon there may be no one around to
help the Tryers."
That's the way it goes' " replied Marketas.
"The only proper role of government is to take care of the Bullys so that the free market can work. Then
everyone is free to produce whatever he can and keep whatever he earns. The only thing government should do
and the military to protect everyone from Bullys and protect everyone's
earnings from theft."
"But we can do better," said Father Fair. "We all agree that a state of nature is unfair, that it rewards the
Bullys and harins everyone else. So we agree that we needed to create a government, and that our government
should levy taxes, pay the police and military, and unleash a free market. And we agree that we should instruct
our government to let the Productives earn and consume more than any other family because they produce more
and we all benefit from their skill and energy. But why shouldn't we also instruct our government to help people
like the Tryers?"
"The free market is natural," answered Marketas, "and the out-comes of a free market should therefore be
accepted as natural. I'm opposed to our government tampering with the natural outcomes of a free market. Such tampering is unfair and unnatural"
"But," replied Father Fair, "while the free market is wonderfully productive, it is not natural. In the state of
nature there was no free market. The Productives suffered along with everyone else. It was the Bullys who
triumphed in the state of nature. We needed to invent our government in order to create a free market. But once
we recognize that the free market is not natural and depends on our government, it makes sense to ask whether
we should instruct our government to do anything else. Shouldn't we use our government to help the Tryers as
well as helping the Productives?"
Marketas shook his head. "The only way to make the Tryers better off is to make the Productives worse off.
You could instruct our government to take so many coins from the Productives and give so many coins to the
Tryers that they would consume equally. But not only is that unfair-after all, we all benefit more from the
Productives than the Tryers- but it would destroy the incentive of people to become as productive as they can be.
Why make the effort to develop skill if you will not be allowed to consume the fruits of your higher skill? And
if potentially productive people don't develop their skill, we will all miss the products they could have invented
but didn't."
"I agree, Marketas' " replied Father Fair. "If we instructed our government to tax the Productives so much
and give so much to the Tryers that they both consumed equally, the outcome would be both unfair and
disastrous. Neither the Productives nor the Tryers would work at all. But I'm proposing something much less
extreme."
"Tell us," said Earnest.
"We should instruct our government," replied Father Fair, "to set up three social insurance programs: unemployment insurance, Social Security, and health insurance. The first would pay benefits to the
unemployed; the second, to the old; and the third, to the sick. Our government would raise the coins it needs for
social insurance by taxation."
"You better not be too generous with these social insurance benefits," warned Incentivas. "If you give an
unemployed person a benefit as high as her former wage, she won't try to get another job. If you give an old
person a benefit as, high as her former wage, she won't save anything when she's working age, and our banks
won't have the funds to lend to businesses to make investments in technology from which we all benefit. And if
you pay the entire medical bill of a sick person, she will have no incentive to consider cost when she orders
medical care and we will all pay inflated taxes to cover her inflated medical costs."
"Your warnings are wise, Incentivas," replied Father Fair. "We must strike a balance. The unemployed person
must get a benefit that is only a percentage of her former wage, so she can survive but still has a strong
incentive to find another job as quickly as possible. The old person must get a benefit that is only a percentage
of her former wage, so she can survive but still has a strong incentive to do some saving when she is working
age. And the sick person must get a benefit that is only a percentage of her medical bill, so she can afford
medical care she needs but still has an incentive to weigh the cost of anything she orders."
"Would these percentages be the same for everyone?" asked Earnest.
"I think it would be better," replied Father Fair, "to vary the percentages. Low earners like the Tryers should
be given a high percentage, because despite their effort, their wage is low and they can hardly afford to save
anything. Low earners like the Tryers might receive a benefit for unemployment or old age that is 60 percent of
their former low wage, and a benefit that is 95 percent of their medical bill; high earners like the Productives
might receive a benefit for unemployment or old age that is 20 percent of their former high wage, and a benefit
that is 75 percent of their medical bill. In other words, I favor a progressive benefit schedule for social
insurance programs- the lower the earnings, the higher the percentage "
"I have one problem with your medical percentage," said Earnest. "Some unfortunate people incur enormous
medical bills. The low earner may not be able to afford to pay even 5 percent of the whole bill, and even the
high earner may be unable to afford paying 25 percent of the whole bill."
"You're right:'replied Father Fair. "Under my medical benefit schedule, once a household has paid an amount
equal to a certain percentage of its income, it would not have to pay any more that year."
"Would this percentage of income be the same for everyoneT' asked Earnest.
"Once again," said Father Fair, "I think it would be better to vary the percentage. For example, it might be 1
percent of income for the Tryers, but 5 percent of income for the Productives."
"But why should we instruct our government to provide insurance?" asked Marketas. "Insuras and her family
do a nice job of selling private insurance under our free market. Why can't we rely on private insurance for
unemployment, old age, and medical care?
"Economas turned and faced Marketas. "My dear Marketas, you know I teach the virtues of relying on the free
market for almost everything we make. I argue vigorously against Socialas who wants our government to
employ everyone and make everything. We need a free market with competition, not a government monopoly,
to have a productive economy. But our beloved free market does a poor job with certain kinds of insurance.
Tell me, what kind of insurance does Insuras sell?"
"Mainly wagon and home insurance," answered Marketas. "With wagon insurance, you're covered if your
wagon injures someone and you owe huge damages. With home insurance, you're covered if a fire destroys your
home."
"Yes:' said Economas, "Insuras does a nice job with wagon and home insurance. But does Insuras sell
unemployment insurance?"
"Come to think of it," answered Marketas, "she doesn't."
"No, she doesn't," said Economas. "And do you know why not?"
"No, " answered Marketas, puzzled.
"Because:' continued Economas, "she would be glad to sell unemployment insurance to the Productives even
at a low price, because they'll probably never become unemployed. But the Productives won't buy insurance,
because they can handle a brief unemployment spell with their own saving. On the other hand, Insuras won't
sell insurance to the Lazys, who would immediately start collecting forever. She might like to sell to people like
the Tryers, but she can't always tell whether a person will act like a Tryer or a Lazy. If a person wants to buy
insurance, there's a good chance he'll act like a Lazy. So Insuras would have to set a high price. But then the
Tryers won't think it's a good deal, only the Lazys will buy it, and Insuras will have to raise the price even
further. Eventually, even the Lazys will think it's a bad deal. That's why Insuras doesn't sell unemployment
insurance. We need our government to provide it."
"But," replied Marketas, "Insuras does sell old age insurance (which requires contributions while the person
works and duringretirement pays benefits for as long as the person lives), and medical insurance."
"Unfortunately, Marketas, there are several problems," replied Economas. "Let me begin with old age
insurance. People like the Tryers simply don't earn a high enough wage to be able to afford to save enough for
retirement. They need most of what the Productives pay them to subsist while they're working. So they can't
afford to save enough or to buy old age insurance from Insuras.
"Then there are families like the Unluckies"' continued Economas. "They save while they work, but
misfortune strikes. A few years before retirement they happen to lose their jobs through no fault of their own,
and they're forced to use up their savings until they find another job. Or they put their savings into stocks of
companies that unexpectedly have difficulty selling their products, so the value of their stock plummets.
"Finally, there are the Myopics, who earn a high enough wage, but they just don't think about what will
happen when they get old. They spend all their coins today, and when they get old, they find themselves in
trouble. Perhaps they deserve to starve in old age, but many of us (especially Charitas) won't let them- after all,
they do work hard up until retirement. So we end up bailing them out with our coins, and they get away without
saving.
"Mother Fair interjected, "Rather than the rest of us bearing their burden, it would be fairer to make the
Myopics contribute coins while they're working rather than letting them get a free ride. Only our government
can make them bear their fair share of the burden by taxing them while they work."
"So, " concluded Economas, "while some families save success fully on their own or buy enough old age
insurance from Insuras, many do not. It makes sense to instruct our government to provide old age insurance so
that everyone who worked when they were younger lives decently in retirement. Everyone would earn old age protection by paying taxes during their work life. If a family wants to live better than that, it must save on its
own "
"Would the taxes of workers go straight out to retirees, or instead be invested in stocks and bonds to be used
when workers retire?" asked Incentivas.
"That's a good question," replied Economas. "We should discuss the pros and cons of each method at a future
meeting. Here I want to argue only that our government should provide old age insurance financed by our
taxes."
"What about medical insurance?" asked Marketas.
"Yes," replied Economas, "some families buy medical insurance from Insuras. But, again, the Tryers can't
afford it. And some families, like the Unhealthies, are not offered insurance at an affordable price. One of the
Unhealthies has a chronic costly medical problem. You can't blame Insuras for refusing to offer insurance to the
Unhealthies, because Insuras would lose a lot of money enrolling such costly families."
"Any family," said Mother Fair, "could suddenly come down with a chronic, costly medical problem. Would
that family lose its insurance?"
"Not immediately," replied Economas. "But Insuras purposely limits the insurance contract to one year. You
can't blame Insuras for refusing to renew the insurance as soon as the year is up.
"True, I can't blame Insuras", said Mother Fair, "but I find this situation very disturbing. Any family can lose
insurance just when it needs it most."
"But," interjected Marketas, "the situation is not as bad as that. Insuras often sells insurance to an employer,
and agrees to cover and automatically renew all employees, whatever their medical costs. It's worth it to Insuras
because it is profitable to enroll a large number of families all at once."
"You are quite right, Marketas," continued Economas. "As long as you can keep your job in a large business,
your family is safe. But if you leave that workplace because you're too sick or too old, or become self-employed, employed by a small business, or unemployed, you're in trouble. Insuras will either charge you a very
high price or refuse to sell you insurance."
"That could happen to any of us," said Mother Fair. "It will definitely happen once we get too old to work."
"So," concluded Economas, "while some families successfully obtain renewable medical insurance as long as
they work for a large business, many do not. And even these families worry that they may lose this employment
and medical insurance. It makes sense to instruct our government to provide medical insurance so that every
family, lucky or unlucky, knows it will always be able to obtain needed medical care. Remember, every patient
would be required to pay a percentage of her own medical bill until the burden becomes too great in a single
year. Our government should provide universal, fair medical insurance, not free medical care.
The Social Insurance State
"What about the Lazys?" asked Earnest. "They're able to work but they just don't."
"I think we should help them too," said Compassionas. "They have a need for food, clothing, and shelter, just
like the rest of us. My motto is, 'To each according to his need.' So I think we need a fourth program, 'welfare,'
to give coins to the Lazys.
Mother Fair responded, "True, the Lazys have a need, but they also have a responsibility. If we all refused to
work, we would all starve, including the Lazys. It would be unfair to give coins to the Lazys when the Tryers
work so hard to earn enough coins to survive. Welfare should give coins only to people genuinely unable to
work' due to physical or mental incapacity."
"I agree about the Lazys," replied Earnest. "But there are some people, who want to work, but they have low
skill, and have trouble finding an, employer who finds it profitable to hire them even at a subsistence
wage.
""The Lazys say they want to work, but they just can't find a job," said Naivas.
"There is only one way to put someone to the test," said Economas.
"Our government should provide last-resort low-wage jobs, not welfare, for anyone physically and mentally able to work. If someone can't find a job
with a regular employer, that person should be given a last-resort low-wage job."
"But what jobs can the government offer these low-skilled people?" asked Earnest.
"There's plenty of low-skilled work that needs to be done," replied Economas. "Our parks and streets need
constant cleaning. The walls of our buildings need graffiti removed."
"But can the government efficiently operate a jobs program?" asked Earnest.
"It might be better," said Economas, "to have the government contract with private firms to run the work
projects. But the government must pay for the projects and make sure that enough are available so that anyone
who wants to work gets the chance."
"Why must the jobs have a low wage?" asked Naivas.
"Because this work doesn't deserve a wage as high as the Tryers earn from a private employer," said Mother
Fair.
"Moreover," added Economas, "we want everyone to have an incentive to prefer regular jobs to these last-resort jobs."
"But how can they survive on such a low wage?" asked Naivas. "Even the Tryers can barely survive."
"Our government should give a supplement to all low-wage workers," answered Economas, "whether the
person works for a regular employer or in the last-resort jobs program. The supplement wouldn't be welfare
because no one would get it unless they worked and earned a low wage; up to a point, the more they earned, the
more supplement they would get. We can efficiently administer this supplement through our tax system, so I
propose that we call the supplement the Earned Income Tax Credit. I'll explain the details at a future meeting."
"So," Earnest said, "our message will be this: There's no welfare if you can work but don't. But there's always
a place to earn enough to survive: the last-resort jobs program. Though the wage is low, if you work hard, your
supervisor will give you a letter of recommendation to help you get a higher-paying job with a regular
employer."
"But what if someone gets the last-resort job," said Tryer, "but then makes little effort to do the job right?"
"Then that person must be fired," said Mother Fair, "and be given another chance a month or two later. A
month or two without coins might change the attitudes of those who shirk the first time."
"But what about their children?" objected Compassionas. "Should children suffer because their parents won't
work?"
"You ask a tough question," replied Mother Fair. "Remember, the children will be covered by our medical
insurance program, because that will be universal and automatic. But they will still suffer if their parents refuse
to work."
"We can't let lazy people extort coins from us by threatening to let their children starve," said Tryer.
"I agree," said Mother Fair. "Perhaps the best solution is to treat repeated shirkers as being guilty of child neglect. We already remove children from parents who severely neglect or abuse them. Refusing to take a job
that can give your child food is surely severe neglect. Of course, this must be handled carefully, with due
process and sensitivity. Clear warnings must be given. No child should be taken from a parent unless the child
is in genuine danger. And a parent must be able to get the child back by working responsibly."
"So our social insurance programs would not make us a 'welfare state,"' said Earnest. "There would be
welfare only for those physically or mentally unable to work. Everyone else would have to work to earn coins.
Perhaps we should call ours a social insurance state."
"I agree' " said Mother Fair.
Educas spoke up. "I very much support our social insurance programs and jobs program. But we need one
thing more. Education helps make an economy productive, but just as important, it is the key to a child's
opportunity. Up until now, our schools have been private, and parents have had to pay the entire tuition
themselves. But some families earn enough coins to pay the tuition of a high, quality school, while others earn
barely enough to pay the low tuition of a low-quality school."
"This is wrong:' said Mother Fair. "We should reduce the quality gap among our schools."
"The solution:' said Educas, "is to levy taxes to pay for schools". The tax each family is assigned should vary
with the family's income. Tax finance will enable children of all families to attend schools with decent quality."
"This doesn't mean," noted Economas, "that the government must use all tax revenue to finance free public
schools. Some of the revenue should be used for scholarships for nonaffluent families, so they have the ability
to switch to a private school if they are very dissatisfied with their public school. That's a subject for a future
meeting."
A Progressive Tax
"I propose' " said Father Fair, "that the government use a progressive tax to raise the coins to pay for the
military, the police, the judges, the schools, and the last-resort jobs program. It's all right for the social
insurance programs to be financed mainly by an earmarked wage (payroll) tax so that each working person
knows he has contributed and has earned insurance benefits through work.But for all other government
expenditures, we should use a progressive tax."
"What's a progressive tax?" asked Earnest.
"It's a tax that takes a higher percentage from the affluent than from the nonaffluent," answered Father Fair.
"Economas, would you give us an example?"
"Certainly," replied Economas. "To keep it simple, let's assume there is only one Productive and one Tryer.
Productive earns 100,000 coins this year, while Tryer, working just as long and hard, manages to earn only
10,000 coins, so the ratio of before-tax incomes is 10 (100,000/10,000). A proportional tax would take the same
percentage from everyone; for example, a 20 percent proportional tax would raise 20,000 coins from
Productive and 2,000 from Tryer, for a total tax revenue of 22,000. Productive would pay 10 times as much tax
as Tryer, and Productive would have 80,000 coins left, while Tryer would have 8,000 left. Note that with a
proportional tax, the ratio of after-tax incomes is 10 (80,000/8,000), the same as the ratio of before-tax
incomes."
"How would the progressive tax be different?" asked Naivas.
"Under a progressive tax," said Economas, "Productive would pay a higher percentage than Tryer. For
example, instead of both paying 20 percent, suppose Tryer pays 12 percent while Productive pays 20.8 percent.
Then Tryer would pay 1,200 coins (. 12 x 10,000) and Productive would pay 20,800 coins (.208 x 100,000),
again for a total tax revenue of 22,000."
"Is that fair to Productive?" asked Arithmetas. "I just calculated that Productive would pay 17.3 times as muchtax as Tryer (20,800/ 1,200 = 17.3), even though Productive earns 10 times as much income as Tryer.
"But," said Economas, "can you tell us, Arithmetas, how many times more would Productive be able to consume than Tryer?"
"That's easy enough," answered Arithmetas. "Productive will have 79,200 coins left after tax, while Tryer
will have 8,800 coins left, so Productive will be able to consume 9 times as much as Tryer (79,200/ 8,800 = 9).
That's remarkable. Even though the progressive tax makes Productive pay 17.3 times as much tax as Tryer, it
still lets Productive consume 9 times as much as Tryer. That's not much less than the earnings ratio of 10."
"But:' warned Marketas, "that drop from 10 to 9 may weaken the incentive of Productive to work his hardest."
"I would still work my hardest if I could consume 9 times as much," said Naivas.
"I admit ' " confessed Productive, "that I would still work my hardest. But you're missing the point. I earned 100,000 coins in the free market. Government has no right to take coins from me. The coins are my property.
I'm entitled to consume 10 times as much as Tryer because I produced and earned 10 times as much ' ""Aren't you overlooking one thing, Productive?" said Father Fair.
"Without a government, taxes, and police,
you would consume the same amount as Tryer, thanks to the Bullys-barely enough to avoid starvation. So if the
government enacts a progressive tax where you pay 20.8 percent and Tryer 12 percent, you would consume 9
times more than Tryer. While 9 times under the progressive tax is not quite as good as 10 times under the
proportional tax, it is still much better than the state of nature, where your consumption would.be the same as
his."
"I'd take 9 times," said Naivas.
"But it's still not fair," insisted Productive. "I produce 10 times as much, not 9 times as much."
"Yes:' replied Father Fair, "you are blessed with the potentiat to develop high skill, and you work hard to
develop it. We all benefit more from you than we do from Tryer, so I agree that you deserve to consume more
than Tryer. But 9 times is certainly a lot more, even if it is less than 10."
"I think the Tryers deserve to consume as much as the Productives"' said Egalitas. "Without government, they
would consume the same, thanks to the Bullys. The Tryers work as long and as hard as the Productives. It's not
their fault that they weren't given the potential to develop high skill. I say the government should tax the
Productives more, and transfer coins to the Tryers rather than tax them, so that each Tryer ends up with the
same coins as each Productive."
"Egalitas, I disagree with you for two reasons," replied Father Fair.
"First, I don't think effort is all that
matters for fairness. True, the Tryers give the same effort as the Productives. But the fact is that the rest of us
benefit more from the Productives than we do from the Tryers. So I think it is fair to weigh actual productivity
as well as effort. Second, your proposal is impractical. It would destroy the incentive of everyone to work hard,
and we would all lose. Each Productive will work just as hard if each gets to consume 9 times, instead of 10
times, as much as each Tryer. But if we make the tax-transfer system much too progressive-if we go to your
extreme of making everyone end up with equal consumption-then we will end up with poverty for everyone
because no one will work hard."
A Progressive Income Tax or a Progressive Consumption Tax?
"I'm persuaded that our tax should be progressive," said Earnest.
"But that still leaves open this question:
Should the progressive rates apply to each family's income or to its consumption?"
"Good question," said Economas. "Which one we choose could have an important effect on our future
standard of living. If families are taxed on their consumption, not their income, there will almost surely be
more saving in our economy. This saving is put into banks that lend it to our business firms so they can invest
in new machinery and technology. Saving is necessary to finance investment, and investment is what makes our
productivity and standard of living rise."
"But is it fair to tax each family according to its consumption, rather than its income, even at progressive
rates?" asked Mother Fair. "After all, consider the thrifty person who earns a high income but consumes little.
He has a high ability to pay. Shouldn't he pay tax according to his ability?""Some are surely persuaded by this ability-to-pay argument," replied Father Fair. "But there is another way of
looking at it. When a thrifty person takes only a small amount out of the economic pie to consume for his own
enjoyment, he leaves more resources for others to consume, or for businesses to invest. That investment raises
the future productivity, wages, and standard of living of everyone. True, he may get pleasure from saving, while
others get pleasure from consuming. But the consequence for the rest of us is very different. The more someone
saves, the higher is everyone else's future standard of living."
"So," said Mother Fair, "you believe that consequences are relevant to fairness, and therefore it is fairer to tax
families according to what they take out of the pie for their own consumption."
"Yes ' " replied Father Fair.
"In that case," said Earnest, "it doesn't make sense to tax people when they transfer wealth through gifts or
bequests, or when they inherit wealth."
"I agree," replied Father Fair. "Giving or receiving wealth does not remove resources from the economic pie.
It does not reduce the resources available for businesses to invest. Only when someone consumes his wealth
should he be taxed, and then at progressive rates."
"Not having wealth transfer taxes would surely be simpler," said Earnest. "But is it practical for each
household to compute its annual consumption?"
"It is," replied Economas. "Each year a household must add its cash inflows, like wages and withdrawals
from bank accounts, and subtract nonconsumption cash outflows, such as deposits in saving or investment
accounts, or purchases of stocks and bonds. What's left is the household's consumption. Of course, it's more
complicated than this. Some things are more complicated under a consumption tax, but others are more
complicated under an income tax. I propose we devote a future meeting to these practical aspects. Whatis certain is that our future standard of living will be higher if we use a progressive consumption tax instead of a progressive income tax."
"And though some disagree' " said Father Fair, "in my view our tax be fairer if we choose a progressive consumption tax over a progressive income tax."
Our Constitution
At the next annual meeting to review the progress of their government, Politicas spoke first. "We should be ture wasn't working, so we came together to form ourgovernment. We immediately agreed on the need for taxes to pay our police and judges, and soon after agreed on even higher taxes to pay our military. Socialas made the radical proposal that our government employ everyone and run our economy, but Adam Smith showed brilliantly why we should let the free market guide our economy instead. After Smith spoke, no one except Socialas wanted our government to employ everyone to make all goods and services. Some of us wanted to limit our government to the police, courts, and military. But the majority wanted our government to use taxes to finance several social insurance programs, a last-resort jobs program, welfare only for people genuinely unable to work, and elementary and secondary education. The majority opted for a progressive consumption tax to finance all government expenditures except the social
"Instead of remaining in a state of nature," continued Politicas, we entered into a social contract, specifying
what our government would and would not do. Now that we have experimented, I propose that we embody our
social contract in a written constitution. This will prevent disputes in the future about what our government can
and cannot do, and ensure our rights and liberties. We must be humble enough to allow a procedure for
amending the constitution. But amending it should be hard, not easy, so that it will occur only when a large
majority concur.
"Politicas was nominated to head a committee to draft a written constitution embodying the social contract.
On the day the constitution was ratified by the people, the state of nature was declared gone forever,
permanently replaced by a social contract utilizing a government created by the people for their benefit and
guided by a written constitution. It was a day of celebration.
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Source: Laurence S. Seidman,Economic Parables & Policies: An Introduction to Economics,Third Edition,
(M. E. Sharpe, New York, 2002), p. 161-181.
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