Originally published July 31, 2011 on the New Economic Perspectives blog.
In the last two weeks we asked, and answered, the question: why would anyone accept a “fiat currency” that has no intrinsic value without precious metal backing? We have argued that legal tender laws, alone, are not sufficient because it is generally too difficult for government to enforce them. Further, we know that “fiat currencies” are often accepted even where their use is not required (ie: where there are no legal tender laws, or at least none that are applicable).
We concluded that “taxes drive money”: if a sovereign has the power to impose and enforce a tax liability, it can ensure a demand for its currency. This is the one transaction that government can ensure its “fiat currency” is used: in payments made to itself.
We also concluded that other kinds of obligations will work: if you need the currency to pay fees, fines, or tithes, you will demand at least enough currency to make those payments. And, finally, we argued that an authority that monopolizes a needed resource (land, energy) can “name the price”, i.e., dictate what must be delivered to obtain it. So that, too, could drive a currency—and, again, it is because the authority can choose the form in which the payment is made.
The best kind of payment is an obligatory one—one that must be made to stay out of prison, or to avoid death by thirst. An obligatory payment that must be made in the sovereign’s own currency will guarantee a demand for that currency.
And we argued that even if one does not owe taxes (or fees, etc.) to the sovereign, one might still accept the currency knowing that others do have tax liabilities and thus will accept the currency. But how much currency will be accepted? Can the sovereign issue more than the tax liability? How much more?
Imposing and enforcing a tax liability ensures that at least those subject to taxes will want the domestic currency, in an amount at least equal to the tax liability that will be enforced. In the developed nations, the population is willing to accept more domestic currency than what is needed for tax payments—typically government does not find sellers unwilling to sell for its currency.
The normal case—let us say, in the US or the UK or Japan—is that anything for sale is for sale in the domestic currency. These sovereign governments never find that they cannot buy something by issuing their own currency.
To be clear: if there is something for sale with a US Dollar price, it can be bought by delivering US currency. (We will just note a caveat here, to be explained more fully later: sometimes, especially for payments made by mail, paper currency and coins are not accepted. But when a payment is made by check, there is a transfer of bank reserves—a kissing cousin to sovereign currency.)
However, the situation can be different in developing nations in which foreign currencies might be preferred for “private” transactions (payments that do not involve the sovereign). To be sure, the population will want sufficient domestic currency to meet its tax liability, but the tax liability can be limited by tax avoidance and evasion. This will limit the government’s ability to purchase output by making payments in its own currency.
We can get a rough idea of the limit imposed on a government whose population prefers foreign currency. Let us say that the government imposes a tax liability equal to one-third of measured GDP. However, because the informal sector escapes accounting, let us assume that GDP only represents half of the true level of output.
Further assume that government is only able to collect half of imposed taxes due to evasion. This means that collected taxes equal only one-sixth of measured GDP and only one-twelfth of true output and income. (Hello, Greece! Just kidding, but that is one of the claims frequently made.)
At a minimum, in such a situation government will be able to move one-twelfth of national output to the public sector through its spending of the domestic currency (since those who really do have to pay taxes need the domestic currency to meet their obligations).
In practice, the government will probably be able to capture more than one-twelfth of national output because some “private” entities (domestic and perhaps foreign) will want to accumulate domestic currency as well as other claims on government (such as government bonds)—recall from previous discussion that government deficits allow accumulation of net financial wealth in the form of government IOUs. Hence it is likely that government will be able to purchase somewhat more than a twelfth of GDP, while collecting taxes equal to a twelfth of national income, with some households or firms (or foreigners) accumulating the rest of the currency spent as net financial wealth.
(These calculations are necessarily approximate because we are ignoring possible effects of taxing and spending on the behaviour of the population. For example, imposing a tax can drive more production into the “grey market”, leaving measured GDP and taxable income lower.)
To capture a larger per cent of national output, government needs to pursue policies that will a) reduce tax evasion and b) formalize more of the informal sector. Both of those actions would increase taxes on the population and would allow government to obtain more output.
If taxes are at just one-twelfth of national output, it might not be effective for government to simply increase its spending to try to move more resources to the public sector—this could just result in inflation, as sellers would accept more domestic currency only at higher prices (as they already have all the currency they need to meet the tax obligation they think will be enforced). And beyond some point, government might not find any sellers for additional currency.
While it would be incorrect—for reasons explored later—to argue that taxes “pay for” government spending, it is true that inability to impose and enforce tax liabilities will limit the amount of resources government can command.
The problem is not really one of government “affordability” but rather of limited government ability to mobilize resources because it cannot impose and enforce taxes at a sufficient level to achieve the desired result.
Government can always “afford” to spend more (in the sense that it can issue more currency), but if it cannot enforce and collect taxes it will not find sufficient willingness to accept its domestic currency in sales to government.
Put simply, the population will find it does not need additional domestic currency if it has already met the tax liability the government is able to enforce (plus some accumulation of currency for contingency purposes). In that case, raising taxes would increase demand for government’s currency (to pay the taxes), which would create more sellers to government for its currency.
Until government can impose and collect more taxes, its spending will be constrained by the population’s willingness to sell for domestic currency. And that, in turn, is caused by a preference for use of foreign currency for domestic purposes other than paying taxes. While this is not a big problem in developed countries, it can be a serious problem in developing nations.
In this blog, we have presumed government spends and taxes using currency (notes and coins). In practice, governments use checks and increasingly use electronic entries on bank accounts. Indeed, government uses private banks to accomplish many or most transactions related to spending and taxing.
In coming weeks we will provide a more “realistic” account of taxing and spending using bank accounts rather than actual currency. This does not change anything of substance—but it does require some understanding of banking, central banking, and treasury operations, discussed in the following blogs.
