Are Taxes Really Necessary?

Some people question why the government can't simply print the money it needs to spend rather than acquiring it through taxes.  If the government has no income of its own, it may seem absurd to think it could operate entirely without tax revenues.   But in fact it could under certain rather restrictive conditions, which we will explore.

The term government is used here to include the central bank as well as the Treasury.  In terms of government finance, the two can be thought of as consolidated into a single agency.  Without taxes, the government would have to create new money (either cash or dollar credits) for every dollar it spends, or borrow back dollars it has previously spent, or some combination of the two. 

Since the private sector operates primarily with bank-issued credit backed by government-issued dollars rather than with government dollars themselves, the amount of government dollars needed by the economy is quite small.  Indeed the amount the domestic economy can absorb without undue inflationary pressure is limited.  It depends on the amount of cash the public wishes to hold, and the reserve ratio imposed on banks.  In the following we will examine the viability of various combinations of conditions.

Without taxes or borrowing from the public, government spending would create an ever-increasing level of bank deposits and bank reserves.  When a bank acquires more reserves than it needs to back its deposits or can use profitably, it will offer to lend them to other banks, but not at an interest rate below what the central bank would pay.  

With an excess of reserves in the banking system as a whole, there would be little bidding for reserves, and the interbank lending market would be dormant.  Under those conditions, the earning rate on bank reserves would drop to the interest rate offered by the central bank.  If that interest rate were zero, as it is in the US, competition among banks would cause them to offer loans to the public at very low interest rates.  If the low rates continued for an appreciable time, speculative borrowing would likely overheat the economy, especially in the form of asset price bubbles.  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 pays interest on bank reserves.  That sets a lower bound on the interest rates banks would charge on loans, and thereby enables the central bank to 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 then enjoy risk-free income from the interest earned on the excess 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 from the public.  If it borrows enough to soak up the excess reserves, the interbank lending of reserves would become an active market.  In fact that is the modus operandi in most industrial countries today.  However one significant problem would remain.  The amount of government debt held by the public would grow at the rate of government spending.  Together with the public's growing bank deposits created by that spending, serious inflationary pressures could develop over time.

In the US today, government spending amounts to about $2,500 billion per year in an economy of about $12,500 billion GDP.  Without taxes to recapture any part of that spending, the deficit/GDP ratio would be about 0.20.  If sustained indefinitely, and assuming 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 ratio could be sustained indefinitely under more normal conditions.

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 in the long run, government spending would have to be far less than it is in most industrial countries today. 

Next Article       Home