Monday, May 2, 2011
Taxes are Necessary but Buy Nothing
It’s counter-intuitive, but it’s correct. Tax receipts buy nothing. We all think we know all about budgets. And, if we have run a household, a company, or a state government, we would probably be correct as those are users of currency. The federal government is the issuer of currency; the same rules do not apply. Indeed, they are for the most part the opposite, which is characteristic of a floating exchange rate currency.
In a previous post, Gold is Gone, we pointed out that our fiat currency is created by federal government spending to buy goods and services from the private sector. Some of the dollars spent are retrieved by taxation. If, as usual, spending is in excess of taxes, the difference remains in the private sector as savings.
Logically, spending must occur before taxation or there would be no funds to tax. Unlike the family which is fiscally constrained by available resources, federal spending is fiscally unconstrained. It does not need to have income or loans to spend and can spend without limit - not that it should.
A family must have resources like wages, savings, or loans to provide money to spend. The national government creates whatever it needs. It cannot run out of dollars, “go broke,” or face insolvency. This is much different than countries like Greece and Ireland, which are users of the Euro. Similar to our states, all countries that use the Euro are fiscally constrained. Unfortunately, we are still unnecessarily burdened in our thinking by constraints left over from the gold-standard years when our currency was also constrained.
It would be fair to ask, if taxes are not income for government, why does it tax? There are two reasons.
First, taxation makes our currency legitimate, because it creates a need for people to acquire dollars. We could imagine different locations around the country having their own currency to encourage local commerce. In fact, that is done. Those currencies could be unconvertible fiat currencies or convertible to coal or seashells. But, we “are one nation, indivisible with liberty and justice for all.” As soon as the government uses its coercive power to levy taxes that must be paid in its dollars, the local currencies become fiscally constrained and convertible to dollars. Dollars win.
Second, taxation serves to restrain aggregate demand in the private sector. As the government spends to buy the goods and services it needs, the private sector acquires assets and purchasing power. If the total demand of the private sector and the public sector exceeds the nation’s capacity to produce goods and services, inflation or currency devaluation will follow. Taxation prevents inflation.
Neither taxes nor borrowing, as shown previously, are needed for government spending, which is completely different from households. With that knowledge, we can start thinking of metrics less arbitrary than deficit and debt to evaluate the health of our economy. Unemployment and productivity would be much better metrics. In the face of high unemployment and excess production capacity, deficits are actually not all that important.