Usury enforcement as an alternative to capital taxation in pre-modern states

Abstract All governments have an obligation to protect their territory and the wealth within that territory from external predation. In fact, since war has historically resulted in the plunder and destruction of wealth, it seems straightforward to suggest that the cost of providing adequate defense of one’s territory is a function of the accumulated wealth within the territory. Suppose that all wealth in society is capital. The accumulation of capital conveys a private benefit to its owner, but imposes an external cost on society. As with any externality, the optimal tax policy would be to tax capital. The revenue from capital taxation could then be used to finance defense. Such a taxation scheme, however, requires the state has an appropriate level of bureaucratic capacity. During the Middle Ages and the early Renaissance, this sort of state infrastructure did not exist. Yet the rulers of those states faced the same constraint. In this paper, I argue that the enforcement of usury laws during this period replicate the outcome of the optimal capital tax. Lending at interest was prohibited. However, rulers often allowed certain groups to lend in society in exchange for a license fee. This granted monopoly status to lenders. At the same time, rulers imposed binding price ceilings on interest rates. The combination of these three characteristics of enforcement replicate the long-run restriction on capital accumulation of the optimal capital tax and generate revenue that is possibly equivalent to the tax as well. I then model ruler behavior given these incentives. Finally, I use historical evidence from England, Italy, and France to support my argument.