Farm (revenue leasing)

Farming is a technique of financial management, namely the process of commuting (changing), by its assignment by legal contract to a third party, a future uncertain revenue stream into fixed and certain periodic rents, in consideration for which commutation a discount in value received is suffered. It is most commonly used in the field of public finance where the state wishes to gain some certainty about its future taxation revenue for the purposes of medium-term budgetting of expenditure. The tax collection process requires considerable expenditure on administration and the yield is uncertain both as to amount and timing, as taxpayers delay or default on their assessed obligations, often the result of unforeseen external forces such as bad weather affecting harvests. Governments (the lessors) have thus frequently over history resorted to the services of an entrepreneurial financier (the tenant) to whom they lease or assign the right to collect and retain the whole of the tax revenue due to the state in return for his payment into the treasury of fixed sums (rent) in exchange.

Etymology

There are two possible origins for farm.

Derivation from classical Latin

Some sources derive "farm" with its French version ferme, most notably used in the context of the Fermiers Generaux, from the mediaeval Latin firma, meaning "a fixed agreement, contract", ultimately from the classical Latin adjective firmus, firma, firmum, meaning "firm, strong, stout, steadfast, immoveable, sure, to be relied upon".^[1] The modern agricultural sense of the word stems from the same origin, in that a mediaeval land-"holder" (none "owned" land but the king himself under his allodial title) under feudal land tenure might let it (i.e. lease it out) under a contract as a going concern (not as a sub-infeudated fee), that is to say as a unit producing a revenue stream, together with its workers, livestock and deadstock (i.e. implements), for exploitation by a tenant who was licensed by the contract, or firma, to keep all the revenue he could extract from the holding in exchange for fixed rents. Thus the rights to the revenue stream produced by the land had been farmed by the lessor (therefore strictly perhaps the "farmor") and the tenant became the "holder of the farm", or to coin a word, "farmee". Because this was the form of the farming transaction most known to popular society, the word "farmer" became synonymous with a tenant of an agricultural holding.

Derivation from Old English

According to other sources, the word farm comes from Middle English ferme ("farm, rent, revenue; revenue collected from a farmer; factor, stewardship, meal, feast"), from Old English feorm, farm ("provision, stores of food, supplies, possessions; provisions supplied to the king or a lord by a tenant or vassal; rent, feast, benefit, assylum"), from Proto-Germanic *firmō, *firχumō ("means of living, subsistence"), from Proto-Indo-European *perk^wu- ("life, strength, force"). It is related to other Old English words such as feormehām ("farm"), feormere ("purveyor, grocer"), feormian ("to provision, sustain"), and feorh ("life, spirit"). The Old English word is stated by these sources as having unusually been borrowed by Medieval Latin as firma or ferma and to have provided the Old French ferme "farm", Occitan ferma "farm". This is refuted by those sources which state firma to derive from classical Latin firmus.^[2] The word continued the same senses of "rent, farmed office, source of revenue, feast". The meaning "rent, fixed payment", which was already present in the Old English word, was further strengthened due to the word's resemblance to the unrelated (so say these sources) Latin firmus ("firm, solid"), and firmitas ("security, firmness").^[3][4]

Valuation of a farm

The tenant of a farm can only make a profit if he makes a careful assessment of its value. Although modern financial management theory has reduced such calculations to scientific formulae, the mind of the astute financier of past ages would have well understood the calculations involved, whether they were performed mentally or by making marks with a stick in the sand. An estimate is made of the long-term average yearly gross value of the revenue stream in question, which can be derived from examination of past records and accounts, adjusted for any new circumstances affecting the future. Then a discount for a risk element is deducted with a further discount deducted for the time value of money. The risk in question relates to the possibility of some of the debts forming the revenue stream being defaulted on or paid late. This causes variability in the revenue stream. These concepts must always have been second-nature to the successful merchant throughout the ages. The resultant figure forms the maximum rent the tenant is willing to pay to the lessee of the farm. His profit becomes the excess of whatever revenues he can extract from the farm less the rents payable, less his administration, levying and collection expenses. The skill of the tenant of a farm is therefore firstly in negotiating a favourable rent which he does by overstating the riskiness (variability) of the cash flow stream in question and secondly in his management of the debts thus assigned to him, that is to say his skills as a debt-collector and manager in general. He must also be satisfied that he has the ability to enforce payment of the debts, ultimately by use of a court of law, in which he must pay the standard fee for bringing a suit, under the legal system generally instituted by the government authority which is the lessor of the farm. He does not act as the lessor's agent but as a principal.

Historical use

Roman empire

Tax farming was originally a Roman practice whereby the burden of tax collection was reassigned by the Roman State to private individuals or groups. In essence, these individuals or groups paid the taxes for a certain area and for a certain period of time and then attempted to cover their outlay by collecting money or saleable goods from the people within that area.^[5] The system was set up by Gaius Gracchus in 123 BC primarily to increase the efficiency of tax collection within Rome itself but the system quickly spread to the Provinces.^[6] Within the Roman Empire, these private individuals and groups which collected taxes in lieu of the bid (i.e. rent) they had paid to the state were known as publicani, of whom the best known is the disciple Matthew, a publicanus in the village of Capernaum in the province of Galilee. The system was widely abused, and reforms were enacted by Augustus and Diocletian.^[7] Tax farming practices are believed to have contributed to the fall of the Western Roman Empire in Western Europe.^[8]

Feudal England

Mediaeval English kings frequently made grants "in fee-farm", a form of feudal tenure. An example is the following writ of King William II (1087–1100) granting a hundred court to be held in fee-farm by Thorney Abbey:

William, king of the English, to all the sheriffs and barons of Huntingdonshire, greeting. Know that I have granted the hundred of Normancross to the abbot and monks of Thorney to be held in fee-farm for an annual rent of 100 shillings which I order them to pay to my sheriff at Huntingdon. And I forbid any of my officers to do them injury or insult in respect of this.^[9]

Other uses

Besides the Romans, historical examples include the tax collection methods of the Ptolemies, Seljuks, Mamluks, Ottomans, the French State prior to Louis XVI, and Russia prior to 1862. In many cases, such as the Abbasid practice of Iqta, these rights were granted by an authority, in this example the caliph, for services rendered or promised. In the Byzantine pronoia system, similar rights were often purchased from the crown. Though such arrangements in some respects seem similar to the feudal system, there are significant disparities, including continuance of state power and, at least in the case of pronoia, theoretical time limits on the grant. In many cases, including those mentioned, tax rights were not transferable or divisible, unlike feudal fiefdoms.

Advantages

Tax farming was an important step in the history of economic development by providing a method for collecting taxes across a large area without the need for a tax-collecting bureaucracy, or during periods when such a bureaucracy is unworkable or impossible to maintain. Systems of tax farming similar to the Roman model were used in Ptolemaic Egypt, various medieval Western European countries, the Ottoman and Mughal empires, and in Qing Dynasty China. As states become stronger, buoyed up by revenues brought in by tax farming, the practice was discontinued in favour of centralized tax collection systems. In part this was because tax farming systems tended to rely on wealthy individuals outside the state machinery, gangs, and secret societies.^[10]

Disadvantages

The key flaw in the tax farming system is the tension between the state, which seeks a long-term source of taxation revenue, and the tax farmers, who seek to make a profit on their investment in as short a time as possible. As a result, tax-farmers often abuse the taxpayers in various ways, tending them to switch their economic activity from strategic long-term projects to short-term revenue generation. A common abuse by tax farmers is the undervaluation of goods received in lieu of taxes, allowing the tax-farmer to re-sell the goods to create a second profit source. Such abuses stifle economic growth by restricting the ability of the tradesman to reinvest in his business, thereby limiting the quantity of taxes generated over the long-term.

Modern-day tax farming

Indian sub-continent

In Bangladesh and India tolls on bridges and roads and dues from public properties such as lakes and forests are often leased to private persons or firms.

Disambiguation

Privatized tax collection

Tax farming is not synonymous with modern privatized tax collection, where private individuals or companies collect taxes and pass them to the state in return for a commission or fee, without bearing any risk consequent of default by the taxpayer. Tax farming is speculative, meaning that the tenant of the farm bears the full risk of defaulted debts. In addition, a tenant is often required as a term of the lease to make an early rent payment, which must be financed from his own resources until the revenue stream subject to the farm has started to be collected.

Factoring

In the United Kingdom, some tax collection of "lower value debts" by HMRC has been out sourced to debt collection agencies from July 2010.^[11] However, debt collection agencies, like invoice factors, are not truly farmers of revenue streams, as they do not bear any risk of default. Rather they make loans in expectation of future receipts, such loans being always recoverable and secured on the income stream itself.

Simple commutation

In 1999 the National Board of Revenue in Bangladesh (NBR) negotiated with cigarette producing firms a minimum amount of Value Added Tax (VAT) that should be paid per month even though VAT is an ad valorem tax, that is to say of variable yield. The NBR took this step because under the self-clearance system monitoring of production and sales of cigarettes proved to be difficult. It was agreed that if the cigarette producing firms paid the minimum revenue fixed by the NBR, physical monitoring would be withdrawn. The NBR resorted to this technique of financial management to avoid the large costs of monitoring while gaining more in revenue with certainty.^[12]

See also

• Maona
• Privatized tax collection
• Ferme générale

Further reading

• Chowdhury, F. L. (2007): NBR's attempt at Tax Farming - fixed VAT on Cigarettes in 1999, Desh Prokashon, Dhaka.
• Levi, M. Of (1988), Rule and Revenue, California Series on Social Choice and Political Economy (13), University of California Press.
• Stella, P., (1992) Tax Farming: A Radical Solution for Developing Country Tax Problems? (September 1992). IMF Working Paper No. 92/70.

External links

• Roman Taxes

References