Missing Link in Tax Overhaul

By J. D. Alt

In Tuesday’s Wall Street Journal (Capital Journal, Looking Past Fiscal Cliff to a Genuine Tax Overhaul) Gerald Seib lays out a very sensible argument about why the U.S. tax code needs to be rewritten “for the 21st century.” He points out that the tax code we are using was created in 1913 (before the Great Depression and the New Deal, I might add) and was last revised in any meaningful way in 1986—“before the Internet had any commercial use, before most of us had cellphones, before the U.S. began running $1 trillion annual deficits, before the oldest baby boomers retired, before income inequality had become a global phenomenon, before the advent of the euro, and before China, rather than Japan, became America’s main economic competitor.”

Mr. Seib left out, however, one very important “before”: The existing tax code was written before Richard Nixon took the U.S. off the gold standard, with the rest of the world soon following suit. In many ways, this “before” is way bigger than any of the others—and it’s also telling that it wasn’t on Mr. Seib’s list.

Why is it so important? In 1913 a freshly printed U.S. Dollar came with the solemn promise that the Federal Government would exchange that Dollar, on demand, for a fixed amount of gold. The ramifications of this promise were profound. First, the promise meant that the number of Dollars in circulation had to be carefully limited. If too many dollars were issued and people began to sense there was not enough gold to back them up, there could be a run on the Dollar, the U.S. Treasury would lose its gold, and the remaining Dollars would be worthless.

Second (and specifically relating the issue of taxes) the promise meant that in order to spend Dollars, the Federal Government needed to collect (in the form of taxes) Dollars it had already issued. If, instead, it simply issued new Dollars for its spending, it would threaten to increase the Dollars circulating beyond what could be backed with gold.

Third (and specifically relating to the issue of the federal deficit) the promise meant that if, for whatever reason, the Federal Government was required to spend more Dollars than it could collect in taxes, it then had to borrow Dollars it had already issued in order to make up the difference. If, instead, it simply issued new Dollars to make up its spending shortfall, it would (once again) threaten confidence in the Dollar’s gold-backing.

While the Federal Government was the only entity that could legally issue U.S. Dollars, the number of Dollars it could safely issue was limited by the amount of gold in the Treasury. The gold standard, then, by limiting the number of Dollars available to both the Public and Private sectors, had the affect of directly linking federal spending with federal tax collection and borrowing. This linkage still exists, very powerfully, in the minds of mainstream economists, politicians, and op-ed columnists: Federal Governments HAVE to collect taxes—or borrow—in order to have Dollars to spend. Where else could the Dollars come from?

Enter an expanding group of economic thinkers, known as “Modern Monetary Theorists,” who are focusing attention on an underlying truth everyone else seems to insist on ignoring: The need for the direct linkage between federal spending and federal taxing and borrowing was eliminated, in one fell swoop, by Richard Nixon! Today, without the gold standard, the linkage is only imaginary—a left-over system of checks and balances that is no longer even logical in the real world of “fiat” currency we now use. And if we remove this now imaginary linkage from the debate about taxes and deficits, the conversation changes rather dramatically.

Today, a U.S. Dollar comes with a very different promise than it did in 1913: What the Federal Government promises today is that it will accept a Dollar as payment for taxes, fines, or fees payable to the U.S. government. That’s it. That’s the only thing a “today” U.S. Dollar stands for. Once again, this promise has profound implications. The first is that while the number of Dollars in circulation still has to be limited, the ONLY issue that informs and creates that limit is inflation. As long as Dollars being issued into the Private sector are being used to create new goods and services (rather than simply increasing the price of existing goods and services) there is nothing (except the whims of Congress) limiting the number of Dollars the Federal Government can issue.

Second, as long as there is excess capacity in the economy—unemployed people looking for work, factories and businesses working below capacity—the Federal Government does not need to collect taxes in order to spend Dollars. It can simply create new Dollars and spend them instead. As long as the real resources are available (e.g. raw materials and under-employed labor), and as long as the new Dollars are actually used to employ these under-utilized resources, there is no reason to expect the new Dollars will create inflationary pressure on the currency.

Federal spending, then, is a flow of new U.S. Dollars into the Private sector, and federal taxes are a flow of issued Dollars OUT of the Private sector. There is no direct linkage between the two. The issued Dollars flowing out as taxes are not recirculated back in the form of spending—they are simply “destroyed.” Federal spending is always with new Dollars. It is easy to see why this is true: Since the Dollars are not convertible to anything other than themselves, there is, literally, no difference between, on the one hand, the Federal Government collecting a tax Dollar, depositing it in the Treasury, and then spending it—or, on the other hand, collecting a tax Dollar, destroying it, and then creating a new Dollar to spend in its place. The end result is exactly the same. And since the vast majority of both Federal Government spending and tax collecting is done electronically, the “destruction” of Tax Dollars coming out of the Private sector, and the “creation” of New Dollars being paid into the Private sector occurs automatically. (Yes, if you happen to send cash Dollars to the IRS, they electronically note the tax payment and shred the cash.)

If what the new economic thinkers are saying is true, then what today we are calling the federal “deficit “is something quite different than what we believe it to be. The famous national debt clock that tallies up the federal “deficit” in real time ($16 Trillion and counting) convincing anyone watching that the flickering numbers represent a number that can never—ever—possibly be repaid are, in fact, adding up something quite different instead. The math is very simple; you can do it in your head:

The Federal Government spends 100 new Dollars into the private sector. (Let’s say it pays for a Medicare check-up.) Those 100 new Dollars get issued into the bank account of the Medicare doctor. The Federal Government then collects 20 of those issued Dollars from the doctor in taxes. The Federal Government has “spent” 100 Dollars and “collected” 20 Dollars. The government therefore has what we are telling ourselves is a “deficit” of 80 Dollars (and the national debt clock flips a few digits.) But what we are calling the government’s 80 Dollar “deficit” is actually the 80 Dollars remaining in the Medicare doctor’s bank account. In other words, what the flickering debt clock is actually measuring is NOT a debt the Federal Government has to repay anyone; instead it is simply measuring the U.S. Dollars remaining in the bank accounts of businesses and households after taxes have been collected.

If the above paragraph is true, then what could “reducing the deficit” possibly mean? Any effort to modernize the U.S. tax code would do well to take into account the answer to that question.


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