IN 1794, LONG-STANDING grievances boiled over, and outraged farmers banded together in widespread revolt. Officials responded with deadly force: shots were fired, and several people killed, before government forces finally prevailed.
It wouldn’t be surprising if you mistook this as an episode from the French Revolution. But, in fact, it occurred in western Pennsylvania—an event that severely shook the early American nation, and its first president, George Washington. Although the Whiskey Rebellion was eventually suppressed, it permanently reshaped American politics.
So what was the fighting about? Taxes. Facing a large debt after the War of Independence and unable to raise taxes any higher on imported goods, the Washington administration, at the suggestion of Treasury Secretary Alexander Hamiton, enacted a tax on whiskey distillers in 1791. Whiskey was a popular drink at the time, so such a tax could raise a lot of revenue. Meantime, a tax would encourage more “upstanding behavior” on the part of the young country’s hard-drinking citizenry.
Yet the way the tax was applied was perceived as deeply unfair. Distillers could either pay a flat amount or pay by the gallon. Large distillers could afford the flat amount, but small distillers could not and paid by the gallon. As a result, the small distillers—farmers who distilled whiskey to supplement their income—paid a higher proportion of their earnings in tax than large distillers.
Moreover, in the frontier of western Pennsylvania, cash was commonly hard to acquire and whiskey was often used as payment in transactions. By discouraging small distillers from producing whiskey, the tax left the local economy with less income and fewer means to buy and sell others goods.
Although the rebellion against the whiskey tax was eventually put down, the political party that supported the tax—the Federalist Party of Alexander Hamilton—never fully recovered its popularity. The Whiskey Rebellion paved the way for the emergence of a new political party: Thomas Jefferson’s Republican Party, which repealed the tax in 1800.
There are two main morals to this story. One, taxes are necessary: all governments need money to function. Without taxes, governments could not provide the services we want, from national defense to public parks. But taxes have a cost that normally exceeds the money actually paid to the government. That’s because taxes distort incentives to engage in mutually beneficial transactions.
And that leads us to the second moral: making tax policy isn’t easy—in fact, if you are a politician, it can be dangerous to your professional health. But the story also illustrates some crucial issues in tax policy—issues that economic models help clarify.
One principle used for guiding tax policy is efficiency: taxes should be designed to distort incentives as little as possible. But efficiency is not the only concern when designing tax rates. As the Washington administration learned from the Whiskey Rebellion, it’s also important that a tax be seen as fair. Tax policy always involves striking a balance between the pursuit of efficiency and the pursuit of perceived fairness.
In this chapter, we will look at how taxes affect efficiency and fairness as well as raise revenue for the government.