Politicians and pundits tend to argue about what to do, but few people actually think about how to do it. State finance is the how of politics and policy. We can dream big dreams, imagining all the great problems that government can solve. However, without the funds to pay for it, none of it can be possible.
This is where "state finance" comes into play, meaning the ways that governments pay for their activities.
Governments gather money in two ways: borrowing and taxation. Between the two, taxation is generally more important for the simple reason that lenders care how they will be repaid and thus are very concerned with taxation. So in order to borrow money, a country needs to be quite capable of collecting taxes (or monopolizing some valuable resources such as oil). A country that does not engage in broad based taxation will likely be incapable of finding investors.
In essence, state finance is prior to anything else that the state can do. Before a government can build a road, fund a hospital or equip an army, they need to find the resources to pay for it. Therefore the question of state finance really sets the limits for what a state can do.
The thrust of much of my research is based on this idea: that taxation and budgeting must be understood if we are going to make sense of the history of states and the societies that live in them.
The famous economist Joseph Schumpeter, wrote in an essay from 1919 entitled “The Crisis of the Tax State”:
The spirit of a people, its cultural level, its social structure, the deeds its policy may prepare—all this and more is written in its fiscal history, stripped of all phrases. He who knows how to listen to its message here discerns the thunder of world history more clearly than anywhere else.
Schumpeter's essay, and especially this quotation, has served as a rallying cry for scholars using taxation and budgeting as an avenue for intellectual inquiry. The fiscal sociologists, as they might call themselves, do not discount other factors in history or in society, but rather see this lens as the most fruitful avenue for taking stock of various historical phenomena. Schumpeter claimed that we could move beyond the politics and even the economics by studying state finance, we can actually go down a number of fascinating roads.
For example, studying state finance can help us to understand the legitimacy of governments—based on, for example, tax compliance or conflicts over payment. This same approach, tax compliance, can be used to research evolving cultural attitudes towards government, or record keeping, or business, or even sovereignty over territory. State finance can also be used as a barometer for development. Through the kinds of tax laws in force and how they came to be, we can understand the stages of evolution for processes and ideas as large as capitalism, democracy, modernity and administrative capacity. On the other side of it, we can look at how financing a state, and what is done with that money, can affect citizens. Tax policy is about how much of a country's output should go to the state. There is the obvious economic question about balancing a tax burden with the needs of the economy, governments do not want to sap out too much cash from consumers. But there are larger questions that are prior to mere economic calculations. What is the balance between a citizen's willingness to pay and the services that may be rendered? Do we, as societies, even understand that we pay taxes and get something (security, education, infrastructure, etc.) in exchange?
The possibilities for studying state finance are enormous, and as it stands now, there are not so many scholars who are interested in studying the subject, probably because the word "tax" forces (some) people into a boredom induced coma. Obviously, I do not think so. Taxes are fun! Taxes are great!
My dissertation and current work focuses on the Polish state during the period between the First and Second World Wars. This provided me with a concise case study in which the state was built up from nothing. Using tax and state finance as a guiding light I have been able to write a new narrative of the period.
What I show in my work is the way that the state evolved to meet challenges and solve problems. This is the aspect of my work that I believe shows a general truth. When any country in the world endeavors to address fundamental problems—let's say infrastructure—then it is necessary to gather enough resources from the population to pay for those new roads, bridges, waterworks, etc. But even before that tax revenue can be collected, there needs to be a capable tax administration in place with a set of legal principles standing behind it. On top of all that, citizens need to understand their tax responsibilities in order to comply or they need to be compelled through a real threat of enforcement. This is a tall order for established countries, but for new states or developing countries, bringing together the necessary preconditions in order to regularly collect taxes from their citizens can be long and painful processes.
The undertaking of growing state capacity presents a contradiction. In order to expand state capacity, the government needs more money, but in order to get more money (without loans) then the government needs a fair justice system staffed with highly educated professionals, an army of tax auditors, widespread recognition of authority, and a number of other factors. But of course, a capable, efficient and sizable administration is very expensive to recruit and maintain. In some cases, it can take generations before enough people with the education and experience are in a position to administer complex tax systems. Poland only had about twenty years to accomplish this, and it is no wonder then that it lacked the financial resources necessary to run a very large state trapped between two aggressive neighbors, Germany and the Soviet Union.
The graphs and charts below will elucidate some of the aspects of my project on interwar Poland and are a simple visualization of the process of state growth.
THE BUDGET:
The graph above presents expenditures and income in real terms for the period between 1921-1939, with the red line as revenue.
Straightaway we can observe the enormous budget deficits that resulted from the period of inflation and hyperinflation (1921-1923). At the same time, the state's budget was relatively miniscule. It is important to note that throughout the entire period, Poland's budget was quite small in comparison to its neighbors, and a tiny fraction of what countries today spend.
The huge jump that we between 1923 and 1924/25 is indicative of the massive financial overhaul of the country led by Władysław Grabski. During this period, Grabski (serving as prime minister and finance minister) introduced a new currency and reformed the taxation system. This combined action allowed for much higher revenues and economic stability.
The rising tide of spending and income shows us the economic fate of the country, as markets improved throughout the late 1920s. Poland even had its first budget surplus in 1928/29.
The drop off thereafter is of course indicative of the Great Depression, which hit Poland particularly hard. However, we see that the gaps between spending and revenue are relatively small. This fact shows us that Poland maintained very conservative budgetary (and thus monetary) policy. Poland held on as one of the last countries still maintaining the gold standard, which pegged its currency to the value of gold. The gold standard was held up at the time as a guarantor of currency stability, but it also meant that the country had very little flexibility in spending. Any spending had to be covered with income from taxes, and deficits covered by the sale of bonds.
Practically every other country—notably Nazi Germany—threw off the constraints of conservative monetary policy for the purposes of spurring an economic recovery out of the Depression, and to fund armaments spending. But Poland held on to antiquated economic ideals about budget deficits and the gold standard, which severely hampered their ability to provide for their own defense.
The next two charts show how money was spent in the Polish state. You can see how this changed over the years by sliding forward in time. Military spending and education dominate the budget throughout, but there are some curious variables.
Because military spending takes up so much space in the chart I create another chart below that allows you too look into spending without the overpowering presence of the military.
SPENDING:
Education includes spending on all the school buildings around the country and employees. This was obviously a massive undertaking at the beginning of the interwar period since the country required many more school houses than were previously available.
Spending on the ministry of justice (here: "Justice") denotes the funds needed to run court houses and pay judges, but it also included funds for jails and other "reform" programs.
RECOVERY FROM THE DEPRESSION:
The graph above presents state spending for a few countries in a way to allow for even comparison, with 1928=100.
Between 1936-1939, the Polish state spent 8.4% of its gross national product (GNP) on the military. During the same period, Germany increased military spending to 32.3% of GNP and France 15.6%. Poland was obviously a much poorer country than either Germany or France. GNP per capita in Poland was under a third of that of Germany in 1937. All the same it is surprising that military spending in Poland was still so relatively low in light of its clear existential threats in the late 1930s. The discrepancy in military spending comes down to the Polish state’s ability to command the resources of the country, through its administrative capacity and especially through taxation. Taxes were the main factor in limiting Poland’s ability to spend more, even if it had wanted to, on its defense. As the graph shows, in the late 1930s, most countries around the world returned to some level of normalcy in collecting taxes, either collecting more or at least similar amounts to the period before the Depression began. Poland’s tax revenues were still 22% less than their 1928 levels.