Saturday, January 17, 2015

How to run a currency Part II: Taxation for dummies

In Part I, we summarized the basics of how monetary systems actually work in the real world, and in doing so, found that we needed a new glossary of terms to describe many of our familiar government monetary/fiscal operations so as to avoid confusing ourselves. Our old familiar terms simply don’t make sense and make us think that our monetary system works in ways that it really doesn't (they made more sense when we were on a gold standard or perhaps for nations using the Euro).

Sovereign currency-issuing nations are very different from “non-sovereign” nations (“non-sovereign” in the sense that they have given up their national currency or promise to exchange their currency at a fixed rate to, or otherwise created fiscal dependency on, a currency or commodity they cannot produce at will).

If we were to consider an “ideal” sovereign nation (like Freedonia), it would have a government that is “of the people and for the people”, but also a currency that is “of the people and for the people”. In other words, the ability to issue that currency at will for public purpose. Neither the government itself nor the nation’s money should be separate from or not under the direction of the will of the people. It’s theirs to use for their collective needs and desires, via their representatives in government.

  • It’s not the banks’ money.
  • It’s not the politicians’ money.
  • It’s not “The Economy’s” money.
  • It’s the people’s money!  

So how do they do it?

After a sovereign nation is formed, a monetary unit is defined so as to be used throughout the nation to account for all debts, obligations, contracts, valuations and transactions in the country (e.g. “Liberties” in Freedonia, or a Dollar in the US). The people then grant their government a monopoly on the issuance of money that is denominated in that unit. Note: the people don’t have this money so it can’t be first taken from them by the government – it is created and flows into the economy when the government pays for things.

Why? For the expressed purpose of providing the nation with the ability to afford things it otherwise couldn't! The very reason we invented State money is to enable the nation to afford things! We can recruit and pay soldiers to fight off invaders, invest in big infrastructure projects, pay for government employees like judges and air traffic control workers, build schools and universities, fund costly science research, and whatever else the people determine is in their interests.

Now the trick is to get the population to accept this newly created money when the government wants to buy something or pay wages for labor. That’s where taxes come in, at least from a historical perspective. Why would Freedonia accept Liberties? Why would US citizens accept Dollars? These State currencies would all be essentially worthless* until the people of these nations imposed upon themselves, through their representative government, a sufficient form of tax that could only be paid by returning to the government some of its newly issued money. Voila! A national currency has been born! As long as the government maintains some taxation, there will be need for the government’s money.

Economists like to say “taxes drive money” – they create the sufficient condition for a brand new currency to take over and become the nation’s sole form of money. And once it circulates businesses will accept the new government money for products, services, or contracts, and people will accept it for wages and other payments. Each time this happens, new money is created and flows into the economy mostly via credits to bank accounts done through a computer. It’s that simple!

The rest all follows from there

  • Nations direct some portion of their real resources (labor, goods, etc.) because they wish to invest in their nation and people: to develop the nation’s “human capital”, to develop productive capital and infrastructure for commerce and leisure, and to ensure the protection and well-being of the land. Continual investment is essential for a nation to advance, grow, and prosper in a sustainable way.
  • This is accomplished when the people authorize their governments to hire people, procure resources, perform research, build expensive projects, provide incomes for elderly, preserve nature, and much more; all of which is done via the issuance of the nation’s money, not by taking money first from the people. 
  • In responsible and well run governments this authorization should happen via an open and accountable fiscal planning process to ensure that the money is being invested prudently and that proper controls are in place to ensure that the effects of the government’s procurement of resources and labor don’t have negative consequences that outweigh the desired outcomes. And there’s plenty of room for debate and compromise in the rough-and-tumble of democratic processes: it’s unlikely that fiscal planning ever achieves perfection or optimization, but with transparency, accountability, and fair representation the people can have their influence on the outcomes.
  • The government’s spending/investing/paying create positive fiscal flows of new money into the economy, building up the nation’s capital while providing incomes to businesses and individuals.
  • Since the people desire to save some of the government money for future needs, the government allows some to stay in the economy and it accumulates there in banks as net financial savings of all the people and businesses in the nation (and other countries through trade).

So what about taxes? 

Some of the government-issued money, of course, is required to be taken back by the government in taxes, as explained above, to drive the universal demand for and acceptance of the State money as and when it is issued. Note, taxation simply takes back what was first injected into the economy. It is NEVER used or needed to fund the government’s investments.

There may be no greater invention than the sovereign currency-issuing government. It provides a society with the most remarkable of powers: the ability to organize their nation’s labor and resources to do ANYTHING that is feasible. If the people are available to work and have the necessary skills, and the required real resources are available in that nation, the government can ALWAYS issue the money required to pay for the thing to be done. It doesn't mean we should use it for anything and everything, but it means the limitations on our needs are never a question of affordability, but rather relate to the availability of real resources.

Think about how this changes how we view our national choices and the kind of future we can build and legacy we can leave for our children’s children.

Rethinking taxation

It should be clear by now that a sovereign government never taxes to obtain money. Sovereign government don’t have “income” or “revenues”. These terms are unhelpful vestiges of the days of gold standards and mercantilism.

Money is simply the governments IOU that they issue into the economy via spending, and they promise that IOU be returned in payment for the tax obligations imposed upon the people. Payment of taxes is simply a return of the IOU. It’s not income. New IOUs can be issued whenever they want to, so those collected back have no value other than to “warehouse” and re-use to save printing costs (as in the case of paper money).

A sovereign government never needs taxes to cover its investments, spending, retiree payments, interest on bonds, etc. (Of course, any non-sovereign government such as municipalities and states must still tax or borrow to cover their expenditures).

So how should we think about taxation? The following are some general principles to guide us.

  1. First, let’s get the language right.
    • Break all the links between taxing and spending! No more “trust funds” for Social Security or Transportation.
    • End references to governments saving their own money units.
    • Eliminate the words “taxpayer-funded” from our lexicon when referring to the national government.
    • Remove the concept of “pay for” from the discussion of what we should and shouldn’t do with fiscal policy.
    • End the “budget scoring” process. There is absolutely NO reason for government decisions of taxation to be part of discussions of what to invest.
    • This will take some effort to re-train our minds and politics, but it’s essential to restoring a right approach to using our currency and running a government of and for the people.
  2. Set policy and economic goals, and then solve for the right fiscal policy.
    • We have made fiscal policy about foolish accounting methods that have no application to sovereign currency-issuing nations. Toss it all out.
    • We are not balancing taxes with spending – we are balancing the economy as a whole, solving national challenges, investing in our nation’s future, preserving our land and resources, and fostering a prosperous, safe and happy future for our people.
    • Fiscal policy is about the government representation of the people using the currency to efficiently and effectively implement the people’s desired outcomes.
    • The starting position is to define the desired outcomes, then set the tax policy that best achieves them.
  3. Recognize that some form of universal or at least very broad taxation in a nation is what drives the demand for and universal use of the government money in an economy.
    • Maintaining taxation of some kind is important, even if we have progressed so much that the currency is very widely adopted.
    • The key question then becomes what is the best type of tax for this purpose.
  4. Taxation is just one part of the total net inflows or outflows of money from the government into the nation’s economy, along with how we authorize government to make payments.
    • Usually the amount taxed is a bit less than the amount injected. We usually call this the “budget deficit” – I prefer to say positive fiscal flows so we don’t get hung up with the wrong metaphor again and link taxes and spending like households – remember, governments have no income.
    • These flows directly impact the private sector economy – if the positive flow increases the private sector sees a gain. If they drop or become a negative fiscal flow (what we call a government “budget surplus”), the private sector has to see some other area grow or its economy will stop growing or enter recession.
    • If we tax too much or have too small of a net fiscal flow, there will be unemployment and the economy will lose productivity and fall below its potential.
    • So the total level of taxation matters. Economists should be paying much more attention to the net fiscal flows and how they can be optimized for the health of the economy rather than fretting over relatively meaningless accounting ratios like debt-to-GDP ratios and imaginary concepts like trust fund account balances.
  5. Taxation has an effect on the economy. 
    • The questions we should be asking in determining taxation are: i) what is the effect of the tax? ii) Is the effect desired? iii) If not desired, is the effect understood and permitted for the sake of achieving some other outcome.
    • Since taxation reduces disposable incomes it affects the amount of spending power in the economy, for both individuals and businesses.
    • Changes in spending will vary across types of businesses and individuals in different income brackets since their propensity to spend varies considerably.
    • Taxation can cause shifts in investments & portfolios as investors evaluate the after-tax yields or returns.
    • Taxation can affect the level of savings and the how that varies by age and demographics. 
  6. Taxation can be a useful tool to direct or redirect resources in the economy that may be in the public interest but that are not being recognized appropriately through market economic forces. They can be structured to provide incentives and disincentives for spending and investment decisions.
    • For example, the US currently provides significant tax incentives for various capital investments which benefit the very wealthy, while the taxes on the wages of the average worker reduces their spending power and ability to save or invest.
    • Increasing taxes on “bad” things and reducing them on “good” things is a generally accepted principle to help in issues of public health and safety, environmental concerns, or to address societal and economic inequalities.
  7. Political processes are not optimized for tinkering with the economy.
    • It can be difficult for a political process to be counted upon to make necessary adjustments in a frequent manner to help the economy in the way the Central Banks believe they can. 
    • Political processes may not come up with the best answer and they may not be able to react very quickly. 
    • This suggests that much careful analysis should go into designing approaches to fiscal policy, especially taxation but also certain types of spending, to enable the net fiscal flows of the government sector to automatically adjust in a counter-cyclical way to the private sector economy. 
    • Such a “buffer” will result in less taxation and increased spending/investment during times of economic downturn, and vice versa. 
    • This does happen already to some degree (tax receipts go down when incomes and profits fall), but much more can be done to achieve a better outcome. 
    • Many of us would suggest that the primary desired outcome is that the economy maintains full employment of workers, but other outcomes can also be designed in.
  8. And one more time for good measure: not one taxation principle here relates in any way to paying for government spending, financing government, or raising funds to balance budgets. 
    • Throw away that textbook and let’s focus on a balanced economy!

Next, we will put this into practice by rethinking our approach to many of our common tax policies.


* Some nations did create money pieces that could circulate in the country out of commodities such as gold and silver coins which may have helped give confidence to the people that the new money had real value, especially when the nation was young, the government weak, and the imposition and collection of sufficient taxes was insufficient or deemed undesirable. The appearance of a link between a commodity and a currency’s value in history is, in fact, much more dubious and has given rise to much confusion. See the references under "More reading on the history of State money" at the bottom of this link.


My writing is based upon the work of leading economists and scholars in the field of modern money, including (but not limited to) Randall Wray, Warren Mosler, Stephanie Kelton and Bill Mitchell. I don’t claim to originate the ideas contained herein, but hope to contribute to the dissemination of them to a broader audience. I will undoubtedly have statements that are near quotes of their works, for which they deserve full credit. I would include them if I could find them, but I write as an amateur from my thoughts collected over years of reading and listening – alas, I am not a disciplined academic footnote-keeping author. Any errors in fact or logic are my own. Comments and feedback are always welcome, especially if they help find the new and constructive ways to bring others along the journey of discovery.

I urge all readers to participate in helping educate others in this remarkable and hope-filled vision of a shared prosperous future for all. This generation will see a transformation in economics – be a part!