Tax forms on a desk with a calculator and pen

Four Purposes of Federal Taxes

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Federal taxes have four very important functions.

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 what existed in the 1960s.

So we would ‘tax the rich’.

But we don’t like it when people say we should tax the rich to ‘pay for’ federal spending.

We don’t like it because it is factually incorrect, gives the wealthy 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 spends because the currency is a public monopoly. The government does not need taxpayers’ money before it can spend. Taxpayers need the government’s money -public money – before they can pay taxes. And the private sector cannot itself create that money, while the payment of federal taxes requires the use of private bank reserves at the central bank, because only the federal government and its central bank can create those. Those reserves must be spent (or temporarily lent) into the system by the 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 is at least as important as what is sometimes called redistribution, to provide a more just and sustainable distribution of income and wealth. Shrinking the finance sector, where salaries and bonuses have been excessive for years, and many activities have contributed to wealth inequality and financial instability would help. As would shrinking the fossil fuels sector. As would (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 could wrest back control of the state from a privileged elite and their lobbyists.

And we could do 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.

It doesn’t.

A second use of the tax system is to discourage some activities and shrink some sectors while encouraging others. So tax reform should be aimed at more taxation of ‘bads’ and tax design should be (just a) part of our use of the price system to move to a sustainable and just economy. Our neoclassical colleagues talk about taxing negative externalities, but we would rather talk about using the tax system, legislation and the power of the public purse to redesign our economy to make it fit for the 21st century.

A third, and very 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. It is the fact that currency is that which is necessary to pay taxes which 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 yourself 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 IOUs into existence, with you knowing that others need to offer goods and services to obtain that currency, so 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 cryptos, but it is the reason they are not genuinely currencies at all, but instead speculative assets (and assets without any fundamental value, however high beliefs might push their market values).

I have deliberately left 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 until last. This does not mean tax revenues are necessary before the currency issuer can spend. It does not mean you need to raise taxes to balance out more federal spending, when the economy is below its productive capacity at the moment. It does not even mean higher taxes are essential if public spending is increased, when you are at full employment. There are other ways to create the capacity for non-inflationary public spending, which might be preferred. One example is tightening up on the regulation of private credit. Others might include investments to raise productive capacity, the use of compulsory private sector saving, and measures to increase competition and reduce monopoly power.

But I have no problem with the notion that investments in a rapid and comprehensive Green New Deal might require a period of higher taxation. I have already mentioned the taxation of bads. Where necessary, I reject the notion that you can never raise taxes 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 it is.

However, right now, we probably don’t need a higher overall tax take as a share of GDP. 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. And 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 might not help much where this fourth function of federal taxes is concerned – not directly, anyway. Why not? Because the government would not need dollars, but real resources. It is true that the rich don’t have such a high propensity to consume as those on lower incomes. This is why raising unemployment benefit is so positive when you need to raise spending to boost the economy, but cutting taxes on billionaires isn’t. The billionaires don’t cut spending much when you tax them more highly and don’t raise spending much when you tax 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, because it doesn’t fit in with things they take for granted in their model of the economy. They have a model of human behaviour where households are assumed to live for ever (or at least to take into account the consumption opportunities of their descendants, into the infinite future), and to make every decision based on 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 and consumption based on the permanent income hypothesis. They then argue that every household has essentially the same propensity to consume out of permanent income. In other words, in this theory, both you and 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.

Add all this together, and 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. What’s more, boosting unemployment benefit will boost demand no more than giving tax breaks to billionaires. There are a whole range of other silly ideas which come out of 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 they will have the savings to pay higher taxes later.

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

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 you have been told: and we certainly should tax the rich more highly (much more highly in the USA) but not because we need their tax dollars 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, we need to put downward pressure on your wealth.

But we don’t need your dollars.

Originally posted by Steven Hail here:

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