Are Taxes Really Necessary?

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 amount of government dollars needed by the economy is quite small. Indeed the 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 conditions.

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 interest 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 in the long run.

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 acceptable condition. 

Without taxes, it is clear then the government must recapture most of its spending by borrowing dollars back from the public. If 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. 

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