MMP BLOG #8: TAXES DRIVE MONEY

By L. RANDALL WRAY

Last week we raised the following question: Where currency cannot be exchanged for precious metal, and if legal tender laws are neither necessary nor sufficient to ensure acceptance of a currency, and if the government’s “promise to pay” really amounts to nothing more than exchanging one 5 Dollar note for another 5 Dollar note, then why would anyone accept a government’s currency? This week we explore the MMT answer.

Taxes drive money. One of the most important powers claimed by sovereign government is the authority to levy and collect taxes (and other payments made to government including fees and fines). Tax obligations are levied in the national money of account—dollars in the US, Canada, and Australia, Yen in Japan, Yuan in China, and Pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In all modern nations, it is the government’s own currency that is accepted in payment of taxes.


We will examine in more detail in coming blogs exactly how payments are made to government. While it appears that taxpayers mostly use checks drawn on private banks to make tax payments, actually, when government receives these checks it debits the reserves of the private banks. Effectively, private banks intermediate between taxpayers and government, making payment in currency (technically, reserves that are the IOU of the nation’s central bank) on behalf of the taxpayers. Once the banks have made these payments, the taxpayer has fulfilled her obligation, so the tax liability is eliminated.

We are now able to answer the question posed earlier: why would anyone accept government’s “fiat” currency? Because the government’s currency is the main (and usually the only) thing accepted by government in payment of taxes. To avoid the penalties imposed for non-payment of taxes (that could include prison), the taxpayer needs to get hold of the government’s currency.

It is true, of course, that government currency can be used for other purposes: coins can be used to make purchases from vending machines; private debts can be settled by offering government paper currency; and government money can be hoarded in piggy banks for future spending. However, these other uses of currency are all subsidiary, deriving from government’s willingness to accept its currency in tax payments.

It is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations. The government cannot readily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes.

For this reason, neither reserves of precious metals (or foreign currencies) nor legal tender laws are necessary to ensure acceptance of the government’s currency. All that is required is imposition of a tax liability to be paid in the government’s currency.

What does government promise? What does a government IOU owe you? The “promise to pay” that is engraved on UK Pound notes is superfluous and really quite misleading. The notes should actually read “I promise to accept this note in payment of taxes.” We know that the UK treasury will not really pay anything (other than another note) when the five Pound paper currency is presented. However, it will and must accept the note in payment of taxes. If it refuses to accept its own IOUs in payment, it is defaulting on that IOU. What was it that President Bush said?

“There’s an old saying in Tennessee — I know it’s in Texas, probably in Tennessee — that says, fool me once, shame on — shame on you. Fool me — you can’t get fooled again.”

Forgive him as he probably listened to Roger Daltry a bit too much back in his partying days. What he meant is that the sovereign can fool me once—shame on government—but it cannot fool me again. (That, folks, is what led to the creation of the Bank of England! A story for another day.)

This is really how government currency is redeemed—not for gold, but in payments made to the government. We will go through the accounting of tax payments later. It is sufficient for our purposes now to understand that the tax obligations to government are met by presenting the government’s own IOUs to the tax collector.

Conclusion. We can conclude that taxes drive money. The government first creates a money of account (the Dollar, the Tenge), and then imposes tax obligations in that national money of account. In all modern nations, this is sufficient to ensure that many (indeed, most) debts, assets, and prices, will also be denominated in the national money of account.

(Note the asymmetry that is open to a sovereign: it imposes a liability on you so that you will accept its IOU. It is a nice trick—and you can do it too, if you are king of your own little castle.)

The government is then able to issue a currency that is also denominated in the same money of account, so long as it accepts that currency in tax payment. It is not necessary to “back” the currency with precious metal, nor is it necessary to enforce legal tender laws that require acceptance of the national currency. For example, rather than engraving the statement “This note is legal tender for all debts, public and private”, all the sovereign government needs to do is to promise “This note will be accepted in tax payment” in order to ensure general acceptability domestically and even abroad.

Ok we need a cliff-hanger. Here are two questions to ponder for Wednesday:

  1. Does this work only for taxes? Could other obligatory payments work? Like what?
  2. What if you do not, personally, owe taxes? Why would you accept the government’s currency?

24 Responses to MMP BLOG #8: TAXES DRIVE MONEY

  1. Isn't it really the avoidance of penalties for tax evasion that is the driver?So it is the strong enforcement of the tax law that is the key driver rather than taxes themselves.Wouldn't that then explain why states with poor enforcement are the ones that struggle to maintain a stable fiat currency?

  2. 2. What if you do not, personally, owe taxes? Why would you accept the government’s currency?Here finally come the snow ball effect : if a pool of people owing taxes is large enough, additionnal people are inclined to accept the government IOU jut to deal with this pool, therefore, becoming parrt of this pool. That's how soveriegn currencies are accepted beyond their issuer borders…

  3. 1. Does this work only for taxes? Could other obligatory payments work? Like what?One example that leaps to mind is student loans. These are functionally equivalent to taxes that are scheduled to be paid later (when interest payments are made and then when the loan is paid down). Any such financial obligation that the governing authority is both willing and able to enforce through the use of its police power creates a certain amount of demand for the unit of account in which that obligation is denominated.a) Here's a thought experiment – what if Bank of America decided to start giving out loans in its own currency – the BOA Bancer? Would this create demand for Bancers? I am assuming, of course, that it would be legal for BOA to do this, but I have no idea if that is actually true or not.My answer is that it could, but only if the governing authority decided to enforce that private BOA Bancer denominated financial obligation through its police power. Otherwise anyone who took out a loan denominated in Bancers would simply attempt to spend the Bancers (but not likely find anyone who is willing to actually accept the Bancers, thus making them worthless) and then default on the loan without penalty.b) What if BOA decided to make its "Bancers" exchangeable at a fixed 1 to 1 exchange rate with US Dollars? This would make it possible to extinguish liabilities owed to BOA in US Dollars with Bancers, and is in some ways similar to Warren Mosler's proposal that the Greek Government accept Greek Bonds to fulfill Greek tax obligations. This would effectively allow BOAs Bancers to piggyback on the demand that already exists for US Dollars.Well, my answer to this is that it would create a certain amount of demand for BOA Bancers. But only a certain amount. The reason why the demand would be inherently limited, unlike demand for the US Dollar, is that "Bancer Market Vigilantes" could ultimately exchange ALL of the liabilities owed to Bank of America denominated in US Dollars for liabilities owed to Bank of America denominated in BOA Bancers. At that point, we are back at the same situation as in part a) – Bank of America is once again dependent on the police power and the judicial system of the governing authority. If the governing authority decides to use its police power to enforce obligations denominated in BOA Bancers, then it has essentially underwritten Bank of America's fixed 1 to 1 exchange rate between US Dollars and BOA Bancers. Note that at this point, Bank of America might just as well be creating obligations denominated in US Dollars. But if the governing authority decides not to use its police power to enforce obligations denominated in BOA Bancers, then the "Bancer Market Vigilantes" can simply default on their Bancer denominated loans from BOA without penalty.

  4. (Sorry, I split this into two comments because apparently it was too long)Come to think of it, this is basically a description of how private banking works – it works because the state gives banks the authority to create financial obligations denominated in the state's currency, and because the state pledges to use its police power to enforce those obligations, just as it uses its police power to enforce tax obligations. So ultimately, all financial obligations – public and private – are dependent on the willingness and ability of the governing authority to exercise its police power to enforce those obligations. This also goes for any attempt by any non-state actor to create its own currency. Final conclusion: The government's willingness and ability to use its police powers to enforce financial obligations – including taxes, fines, fees, government student loans, private bank loans, etc – in a given unit of account creates a significant foundation of demand for money denominated in that unit of account. However, the total amount of economic exchange that occurs using that unit of account will almost certainly exceed the net value of the explicitly enforced transactions (payments of taxes, fines, fees, government student loans, private bank loans, etc). The rest of the demand for currency is created by custom on top of that foundation. People then exchange currency in all sorts of transactions, because they know that it will be accepted by everyone else.

  5. Anonymous,Very good! As James Tobin (Nobel Prize) said in his 1998 textbook:“In advanced societies the central government is in a strong position to make certain assets generally acceptable media by its willingness to accept a designated asset in settlement of taxes and other obligations. The government makes that asset acceptable to any who have such obligations and in turn to them and to others and so on.”S. Kelton

  6. So if taxes are too low, there is insufficient demand for the government's currency, and it decreases in value, right?IOW, inflation can be driven by taxes that are too low.

  7. Money created by issuing debt requires repayment by a greater sum than was borrowed due to the interest owed. This means that money to repay present debts is dependent upon future debts to supply the money required to make interest payments. When banks decide not to loan money or governments decide not to borrow money, the scarcity of money means loan’s interest payments cannot be made and defaults are forced.Since the universal acceptance of money depends on acceptance of a sovereign’s money for payment of taxes, would it matter if the money were issued without debt but in exchange for the goods and services required by the people who the government are accountable to? Say the government issues coins of a large denomination (mostly seigniorage) to pay for public infrastructure and receives title to the infrastructure in exchange. The assets and liabilities ledger would appear to me to balance in this transaction, putting money into circulation without creating a money scarcity otherwise due to making interest payments on a loan. Banks are great on “pulling the string” to reduce money supply—and causing defaults in the process. They fail when called upon to “push on the string” to remediate collapsing demand in an economy.

  8. @ BaldApe..I would guess whether taxes are low or high would not effect demand for currency… The link between property being confiscated/ punishment if taxes are not paid would be the driver…

  9. @ BaldApe. I would speculate if taxes are raised and the government would not accomodate with deficit spending to offset… would increase unemployment and lower production.

  10. Anon,Say the government issues coins of a large denomination (mostly seigniorage) to pay for public infrastructure and receives title to the infrastructure in exchange. The assets and liabilities ledger would appear to me to balance in this transaction, putting money into circulation without creating a money scarcity otherwise due to making interest payments on a loan. This kind of assumes, however, that the piece of infrastructure is correctly valued. Suppose that the government issues currency to pay contractors to build a bridge. The bridge costs $8m dollars. Now the government owns a bridge, which we say is worth $8m dollars, so the value of the asset (bridge) matches the value of the IOUs issued (currency). However, how do we know that the bridge is worth $8m? Could the government sell the bridge and get $8m back? Could it charge a fee for using the bridge and thus recoup $8m?If not, how do we know the value of the bridge?If we assume that whatever the government pays for is an asset worth what was paid for it, then the government could fund the whole economy by buying a single tootsie roll for $14T each year. And yet, one has the feeling that this would not work, somehow.

  11. "We will examine in more detail in coming blogs exactly how payments are made to government. While it appears that taxpayers mostly use checks drawn on private banks to make tax payments, actually, when government receives these checks it debits the reserves of the private banks. Effectively, private banks intermediate between taxpayers and government, making payment in currency (technically, reserves that are the IOU of the nation’s central bank) on behalf of the taxpayers. Once the banks have made these payments, the taxpayer has fulfilled her obligation, so the tax liability is eliminated."First, when you do the accounting, can you use markup or markdown instead of or in addition to debit or credit? I believe that would be easier for people to follow.Second, what if the tax payments cause a [central bank] reserve shortage?

  12. Darwin, July 25, 2011 10:48 AM Fourteen trillion dollar Tootsie Roll or a billion dollars worth of 10,000 toilet seats.We should all be aware of the same problems of valuation are presently occurring in housing, CDOs, Defense Department funding, prison construction, etc. under the present system. It is not as if there is a system in existence with which to compare efficacy of valuation. How are government contracts given their valuation in the system as it exists? Contract budget overruns are the norm. This problem must be dealt with in whatever system is established. Clearly, a corporate funded government is not immune from self dealing at public expense. Perhaps a referendum should be used to determine the value of public spending. Wars and failed casino banking adventures may not receive the same funding in a referendum that those well connected in the symbiotic military-corporate-congressional complex determine is necessary to serve their interests and not necessarily those of the public. In any case, you can trust the private bankers accountable only to their shareholders to create money (as Greenspan does) or some form of government that is accountable to the public that ultimately bears the burden of the successes and failures of valuation.

    • …Jesus is Risen. Jesus will come again. Can we move on now?***Except that the money is NOT “free”, Doug.It’s borrowed from China and Saudi Arabia, and such.My fenleig: can Our New Global Overlords PLEASE take our multi-millionaires/billionaires off our hands, PHYSICALLY TOO? I’d love to see our hedge-fund managers and investment bankers, oh, say, sewing underwear in a Chinese sweatshop!

  13. "We are now able to answer the question posed earlier: why would anyone accept government’s “fiat” currency? Because the government’s currency is the main (and usually the only) thing accepted by government in payment of taxes. To avoid the penalties imposed for non-payment of taxes (that could include prison), the taxpayer needs to get hold of the government’s currency.It is true, of course, that government currency can be used for other purposes: coins can be used to make purchases from vending machines; private debts can be settled by offering government paper currency; and government money can be hoarded in piggy banks for future spending. However, these other uses of currency are all subsidiary, deriving from government’s willingness to accept its currency in tax payments."I still think that should be "accept government's "fiat" medium of exchange" because both currency and demand deposits can serve all those purposes except maybe the vending machine (depending on the vending machine).

  14. @ Anon,I would say many privately issued "complex derivatives" were a form of 14t tootsie roll which the public ultimately underwrote. I see many bridges which are in disrepair. To determine the value I suppose it is in the eye of the interests which use it. Moody/S&P placed great value on tootsie roles which we can't even eat in the physiological sense now worthless…the public is paying for this. Eating it through unemployment & inflation. A handful of Wall Street insiders benefited at the expense of the real economy by manipulating the FED. So who owes the public/national debt which underwrote the issuance of complex derivatives? It makes perfect sense to issue coins & currency in lieu of debt. Perhaps it could simplify monetary transactions & make more transparent.

  15. what is the percentage of tax where the deincentivisation is greater than the benefit from the extra disposable income that people heve via taxes? (salaries, education ect)

  16. Here's a paradox, or conundrum, not sure what it is that I sense, having trolled about NEP since it was EPKC, points I've put which have sometimes been acknowledged but I still cannot get settled:1) Sovereigns don't NEED to collect taxes to pay for things, it/they create money to spend and 2) The function of tax collection is to redistribute purchasing power between sectors, to drive demand as needed, or prevent inflation as needed. And so again, as much as I appreciate that NEP is attempting to present a "positivist" account of how an economy with fiat currency works – just "the facts" – a description of what there is by accounting and sector identities, etc. – the social/political implications cannot be ignored. At some point, putting MMT into policy (dare I call it "praxis") has to acknowledge the varying interests of the people who benefit or suffer the sovereign's regime.

  17. Dave,Use the word 'tax' for aggregate demand management and the words 'levy/grants' for externalities.Then it becomes straightforward. You levy negative externalities and provide grants for positive externalities. That manages the power of wealth and the abuse of the environment.Tax can then concentrate on aggregate demand management.

  18. Given that tax rates only change at most once a year isn't tax a poor way to regulate aggregate demand? Shouldn't there be a more responsive way for the government to regulate?Let me suggest a way:If instead of income tax there was only sales taxes couldn't, in this day and age, a government alter the sales tax rate at will in order to regulate demand as needed (i.e. weekly or monthly or daily or whatever?)

  19. It is easy to know how a financial system with so called fiat currency works – what is difficult to understand is how an economy works.Do not mix financial system with an economy.Completely different things.

  20. Would this work with zero taxes too? How much lower can taxes go?

  21. I thought where you were going to go with the government’s ability to levy taxes being the basis for acceptance of fiat currency was this: I am willing to accept fiat currency because I know the government can tax its citizens to make good on the promise, whatever it is, printed on the currency. That seems different than the reason you give, though. If I understand correctly, you are saying it is solely because the government chooses to require payment of taxes in its own currency that everyone becomes willing to accept it. OK, is it possible, though, that because of this, “faith” in the fiat money is bolstered by the tax-levying power of the government?

  22. MattyG wrote “So ultimately, all financial obligations – public and private – are dependent on the willingness and ability of the governing authority to exercise its police power to enforce those obligations. ”

    It seems to me there are 3 main ways the police power can secure compliance.
    1. Take prisoners
    2. Seize land
    3. Secure submission through threats or tricks

    And there are only 2 ways the police power can put money into circulation.
    A. Spend it on labor and natural resources
    B. Give it away

    Mode 1A is nothing but slavery. If prison is the penalty for evasion of income tax, this is exactly what we have. If the only way to get money to pay income tax to avoid prison, is to do wage labor for government or a private individual near the source of government spending, then everybody is already a slave right now.

    Mode 2B is similar to serfdom. This would be very fair in my opinion. With government collecting the rents of land, people are free to vote with their feet. The fact that they stay in their homes means they agree to a social contract. If the money is distributed as a citizens dividend, there will not be a big government busy creating millions of jobs. A small government will do. Citizens will have the time, money, and land to practice farming.

    Mode 3 is dishonest and I don’t like it. Potentially though it may be the easiest for the police power to implement.