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Four purposes of federal taxes

Steven Hail

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Federal taxes have four very important functions.
1. The first one I am going to list is to change the distribution of income and wealth. Taxes that take a higher share of the income of those with higher incomes are called progressive. Most of us would return to a far more progressive tax system than exists now – something more like the system that existed in the 1960s. That is, we would ‘tax the rich’.

But we don’t like it when people say that we should tax the rich to ‘pay for’ federal spending. The reason we do not like it is because it is factually incorrect, gives wealthy people too much power, is misleading and biases the policy narrative.

Some economists struggle with the idea that you would want more progressive taxes but not to ‘pay for’ anything. I think it is a very simple notion.

We don’t actually need dollars from the rich before the government can spend, because the nation’s currency is a public monopoly. The national government does not need taxpayers’ money before it can spend.

Taxpayers need the government’s money — public money — before they can pay their tax obligations. The private sector cannot itself create public money, moreover the payment of federal taxes requires the use of public money in the form of bank reserves held in bank accounts at the central bank. Only the federal government working together with its central bank can create public money. Those publicly created reserves in accounts of private banks must be spent (or temporarily lent) into the system by the central government or its central bank, before they can be used to pay federal taxes, or to purchase newly auctioned federal government bonds.

Moreover, pre-distribution (before taxation) is at least as important as what is sometimes called redistribution (after taxation), to provide a more just and sustainable distribution of income and wealth. Shrinking the finance sector, where executive salaries and /bonuses have been excess- ive for years, and where their activities have contributed to wealth inequality and financial instability would help. As would shrinking the fossil fuels sector. As would (and especially) full employment, more union membership and fairer industrial relations legislation, worker representation on boards, different types of international trade agreements, higher minimum wages, and a variety of other practical measures which could be taken if only we would wrest back control of the state from a privileged elite and their lobbyists.

We could do all these things without having to put up with nonsense about how rich people’s taxes are essential to pay for things, if only we could persuade our neoclassical colleagues – including those who describe themselves as ‘old Keynesians’ – to stop saying taxing the rich pays for stuff. Because it doesn’t.

2. A second use of the tax system is to discourage some activities and shrink some sectors while encouraging others. Tax reform should be aimed at more taxation of ‘bads’ and tax design should be a part of our use of the price system to move to a sustainable and just economy.

Our neo-classical colleagues talk about taxing negative externalities, but we would rather talk about making use of the tax system, legislation and the power of the public purse to redesign our economy and make it fit for the twenty first century.

3. A third, and fundamental, function of federal taxation is to create and sustain a demand for the government’s currency, so that the currency issuer can spend that currency into existence to provision itself. The fact that currency is that which is necessary to pay taxes lies behind the general acceptability of fiat money. Fiat money is not based on trust – it is based on coercion, legislation, state power, and taxes and other liabilities which the state imposes on its citizens. It doesn’t matter if you are not a taxpayer.

What matters is that there are enough people out there with the necessity of obtaining currency to pay their taxes to ensure that the government can spend its currency into existence. It then becomes obvious that other people need to offer goods and services to obtain that currency, so that they can pay their taxes.

This is why the narrative you read sometimes about cryptocurrencies is the wrong way around. Fiat money is NOT based on trust. It is backed by tax liabilities. It is cryptocurrencies which are based on trust – there are no obligations and nothing but the beliefs of those holding cryptos which lie behind them. This is not a criticism of cryptocurrencies, but it is the reason why they are not genuinely currencies at all, but instead are speculative assets (and assets without any fundamental value, however high beliefs might push their market values).

4. I have deliberately left until last the function of federal taxes to destroy private spending power, to create room within the productive capacity of the economy for the government to provide public goods without adding to inflationary pressures. This does not mean tax revenues are necessary before the currency issuer can spend. It does not mean that taxes need to be raised to balance out more federal spending, if the economy is below its productive capacity. It does not even mean that higher taxes are essential if public spending is increased, when there is full employment. Because there are other ways in which the capacity for non-inflationary public spending can be created, which might be preferred. One example is tightening up the regulation of private credit. Other examples include investments to raise productive capacity, the use of compulsory private sector saving, and measures to increase competition and reduce monopoly power.

I have no problem with the notion that investments in a comprehensive and rapid Green New Deal might require a period of higher taxation. And in this context I have already mentioned the taxation of ‘bads’. Where necessary, I reject the notion that taxes can never be raised in the event that it is shown federal investments have contributed to demand pull inflation. It is not as though governments have never raised taxes. We have had 30+ years of propaganda (including the misuse of the term ‘supply side policy’ and the ridiculous Laffer Curve) to suggest otherwise. But propaganda is all that these suggestions are.

However, right now, it is not apparent that a higher overall tax take – as a share of GDP – is needed. We can achieve and sustain non-inflationary full employment, based on a green federal job guarantee, as so many modern monetary theory economists (and some others) have argued for many years. We know how to do this. We can create room within the productive capacity of the economy for investments in sustainability and social justice by shifting real resources out of fossil fuels, the bloated finance sector, and other areas of the economy. The mission economy we need may not require higher taxes.

But what if it did? We have suggested that taxing the rich will not help much where this fourth function of federal taxes is concerned – not directly, any- way. Why not? Because the government would not need dollars, but real resources. It is true that the rich don’t have as high a propensity to consume as those on lower incomes. This is why raising unemployment benefit is so positive when one needs to raise spending to boost the economy, but cutting taxes on billionaires isn’t. The billionaires don’t cut spending much when one taxes them more highly and don’t raise spending much when one taxes them even less highly. You know this is true intuitively. Those billionaires might ‘invest’ additional dollars in the stock market, driving asset prices up, and have an impact on the economy like that, but that does not impact directly on inflation.

Some economists dispute this point because it doesn’t fit in with the things they take for granted in their model of the economy. They have a model of human behaviour where households are assumed to live forever (or at the least to take into account the consumption opportunities of their descendants, into the infinite future), and to make every decision based upon maximising the expected utility from consumption of this infinitely-lived decision maker over time. What’s more, consumption in this model does not depend on current income and wealth but instead on ‘permanent income’ (basically expected average future income in this infinite future).

That is, they model human behaviour using expected utility theory as well as consumption based on the permanent income hypothesis. They then argue that households have essentially the same propensity to consume out of permanent income. In other words, in this theory, both you and billionaire Warren Buffett spend the same share of your ‘permanent income’ each year. You don’t spend much of any temporary increase in income, because you spread it out across your infinite life, and it is then insignificant. You save windfalls. You don’t spend them.

Adding all these points together, we see that they think suddenly taking a dollar in tax off the rich does just as much to cut demand in the economy as taking a dollar off a poor person. Furthermore, they think that raising unemployment benefits will boost aggregate demand no more than giving tax breaks to billionaires. A range of other silly ideas is generated by this approach, including – once you ignore how the monetary system works – Barro-Ricardian equivalence, which is the notion that changes in the fiscal deficit have no impact on total spending at all, because tax cuts today (for example) are believed to lead to expectations of higher taxes later, with households spending less today so that they will have savings to pay higher taxes later.

A range of other silly ideas is generated by this approach, including – once you ignore how the monetary system works – Barro-Ricardian equivalence, which is the notion that changes in the fiscal deficit have no impact on total spending at all, because tax cuts today (for example) are believed to lead to expectations of higher taxes later, with households spending less today so that they will have savings to pay higher taxes later.

This (slightly crazy) idea of course ignores the fact that the government is the currency issuer, that aggregate federal debt is not debt in the conventional sense of the term (i.e. that has to ever be paid off), and is instead just the net supply of dollars that the government has spent into the system and not yet taxed back out of it.

But this stuff is floating around in the heads of New Keynesian economists, and quite a few Old Keynesians too, plus old and new Monetarists and Real Business Cycle people.

There is a lot more to say, but I won’t say it here. The basic point I have been trying to make is a brief one.

Federal taxes are vitally important, but not for the reasons most people have been told; and the rich should certainly be taxed more highly (much more highly in the USA) but not for the reason that their tax dollars are needed to pay for anything.

We just need them to be less rich. If you are a billionaire, you are too rich. You are too powerful. You have too much command over real resources. And for the good of social stability, downward pressure needs to be put on your wealth. Your dollars are not needed.

Originally posted by Dr Steven Hail as
Reference: Beardsley Ruml, “Taxes for Revenue are Obsolete,” January 1946, American Affairs.Dr Steven Hail is Lecturer in Economics at Adelaide University, and is an ERA member.

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