|Are Taxes Really
Why can’t the government print the money it needs to spend
rather than acquiring it through taxes. The notion that the government could
operate entirely without tax revenues may seem absurd. But in fact
it could under certain restrictive conditions, which we will explore.
Without taxes, the government would have to create new money
for every dollar it spends, or borrow back dollars it has previously spent, or
some combination of the two. The term government
is used here to include the central bank as well as the Treasury. In terms
of government finance, they can be thought of as consolidated into a single entity.
Since the private sector operates
primarily with bank-issued
credit, which is only fractionally backed by government dollars, the
government dollars needed by the economy is quite small. Indeed
amount of government dollars the domestic economy can absorb without
undue inflatonary pressure is limited. It depends mainly on the
amount of reserves that banks are required to hold. In the
following we will examine the viability of various combinations of
When a bank acquires more reserves than it needs to back its
deposits or can use profitably, it will offer to lend the excess reserves at
interest to other banks. Normally the
government controls the interbank interest rate by controlling the amount of
reserves in the banking system. However
without taxes or borrowing from the public, government spending would create an
ever-increasing amount of bank reserves. Under
those conditions the interbank interest rate would fall to a level determined
by the interest rate the government itself paid to banks on their reserves.
Suppose the government paid no interest on bank reserves. With
an excess of reserves in the banking
system as a whole, the interbank interest rate would fall to
nearly zero. The interbank lending market would be dormant because
there would be little or no demand for reserves. With banks holding an
abundance of reserves acquired at almost no cost, they would offer
loans at very low
rates. If the low rates continued for an appreciable time, the
resulting excess liquidity in the private sector would overheat the
economy and cause serious price inflation.
It is evident then that without taxes, the combination of no government
borrowing and no interest paid on bank reserves is not a viable system
Suppose the central bank paid interest on bank
reserves. That would set a lower bound on the interest rates banks would
charge on loans. The central bank could then influence borrowing
demand and the amount of credit money issued by banks. However without
taxes, continued government spending would create far more reserves in the
banking system than banks would need to back their loans. Banks would
enjoy risk-free income from the interest earned on the excess reserves,
which would continue to grow with government spending. That is not an
Without taxes, it is clear then the
recapture most of its spending by borrowing dollars back from the
it borrows enough to soak up the excess reserves, an active market in
interbank lending of
reserves would be restored. That is the condition
under which most industrial countries operate today. However without
taxes, one significant problem would remain. The amount of government
debt held by the public would grow at the rate of government spending.
The increasing debt held by the public, together with ever-growing bank
deposits created by government spending, would result in
serious inflationary pressures.
In the US today, government spending amounts to about $3,000
billion per year in an economy of about $15,000 billion GDP. Without
taxes to recapture any part of that spending, the deficit/GDP ratio would be
about 0.20. If sustained indefinitely, at a nominal GDP growth rate of
5%, it can be shown that the debt/GDP ratio would be bounded but reach a level
of about .20/.05 = 4.0. That is several times higher than the peak
reached at the end of World War II when the government borrowed heavily in a
highly distorted economy to support the war effort. It is unlikely that
such a high debt/GDP ratio could be maintained in a normal economy.
The conclusion is that taxes are necessary in an economy in
which government spending comprises a significant part of the economy.
For a no-tax system to be viable, government spending would
have to be far less than it is in most industrial countries today.