To stay out of jail and to keep our assets from being seized. That’s the short answer.
But why does the government require that we pay taxes, and why is this requirement important enough to have serious penalties attached to non-compliance?
Some of the reasons we are required to pay taxes may surprise you, as they surprised me when I first learned them. The purposes of taxation are rich topics for discussion, as I hope you’ll see in a minute.
The base case we will use to explain taxation is the present-day United States, which has a fiat (by decree) currency, meaning that the federal government can authorize spending and create cash.
We will touch briefly on the debt in hopes of clearing up the widely-perpetuated misconception about what the debt actually is. The chances of achieving that end are next to non-existent, because discussing the debt in a realistic and critical way has got a snowball’s chance in hell of standing up to the misinformation promulgated by politicians and pundits.
Although some public figures know what the debt really is, it’s such a wonderful talking point and rallying cry that it would be counter-productive to the purposes of those public figures to change a tune that people love listening to. And then there’s all those other talking heads we listen to who don’t have the faintest clue, but we go ahead and repeat what they say without understanding it, because that’s how people are designed (to align with others and thereby increase our chances of survival, regardless of the validity of the organizing principles or ideologies to which we conform). (See this post for more on that phenomenon.)
Okay, tangent complete. We’ll now go over the purposes of taxation and then briefly cover the debt.
The purposes of federal taxation are: (1) legitimize the currency, (2) reduce inequality by restricting a specific type of demand-driven inflation, and (3) create incentives or disincentives for certain behaviors. These are the main reasons why federal taxes exist in a fiat system. State and local taxes exist for all of these same reasons and also to fund spending at the state and local levels.
Federal taxes don’t fund federal spending, however, because the federal government has the power to deficit spend, and therefore is not revenue-constrained.
Deficit spending occurs when there is more federal spending over a period of time than federal receipts over that same period of time.
This occurs when Congress authorizes spending and then increases the debt ceiling in accordance with the newly authorized spending items.
To put it in the popular lingo, this is when the federal government prints money out of thin air. It’s a little more complicated than that but that will suffice for our purposes. (See below for whether our money actually comes from China.)
We could also make up some minor reasons for taxation such as creating jobs for tax administrators, accountants, lawyers, and other professionals in tax, but we don’t need to go there in this discussion, as fun as that may be. Let’s save that for the comments.
Legitimize the Currency
The first purpose of taxation is to legitimize the currency. So you’ve created a new currency, the dollar, now how do you get people to use it? You’ve got to create demand for it. And what better way to do that than to require that taxes be paid in dollars, and make failure to pay taxes punishable by imprisonment and seizure of property?
If you want to stay out of jail, you’re going to have to find some dollars to pay your taxes. And so will everyone who does business in the U.S., so it’s to everyone’s benefit to start using those heretofore worthless dollars as a medium of exchange, that way everyone will be sure to have some on hand when the tax man comes around.
Demand for dollars created, and currency scheme in place!
The next purpose of taxation is to keep inequality at bay, to the extent needed to preserve somewhat equal access to goods and services. This is why we have a graduated tax system that taxes higher portions of income at higher rates, and it is also why we have the estate tax, which is currently being styled, quite lovingly, as the “death tax.”
The point of these types of taxes is to prevent or at least reduce the concentration of wealth in the hands of a few, because if this occurs, then the proverbial 1% may be able to use their vast sums of cash to bid up the price of basic necessities such as food and medical care to such a degree that certain goods and services become inaccessible to all but the wealthiest people.
For example, it is conceivable that if wealth continues to concentrate in a segment of the population unchecked, certain foods may be bid up by the wealthy to a degree that these foods become unaffordable to the less wealthy. To some extent this occurs due to supply price-setting behaviors for luxury items, but this second purpose of taxation seeks to limit the over-appreciation of basic, life-supporting items that we all need.
Create Incentives and Disincentives for Certain Behaviors
Finally, the tax system serves to incentivize and disincentivize a broad range of behaviors. Although this may be viewed as paternalistic and limiting to our freedom to choose for ourselves, I believe some of these incentives are objectively justified for the common good.
Examples will be helpful here. High taxes on cigarettes seek to discourage smoking, which carries with it negative effects for smokers, their children, those around them, and those who need access to healthcare resources that are taken up by caring for smoking-related illnesses.
Tax-benefited retirement accounts encourage individuals to put money away for the future, lessening the need placed on their families and the public sector to provide support for them in the future.
The mortgage-interest deduction is a very interesting one to me, because in encouraging home loans, the government is incentivizing homeownership and borrowing for homeownership. The lending industry is benefited by encouraging the borrowing. But what are the benefits to society of homeownership itself?
There are a few to consider. Homeownership instills pride in one’s property, and instills feelings of respect for the property of others, and leads some to civic engagement. Civic engagement may benefit communities at large, to the extent it goes beyond bickering on neighborhood email groups.
Owning a home also decreases mobility, which helps provide a stable workforce for employers. And, while we’re on that note, mortgages keep people working longer, because monthly payments require most people to maintain regular income. And, still more on that one, mortgages allow employers to keep wages lower, because they know their employees have got bills to pay and might not want to risk leaving even if their pay doesn’t rise as quickly as desired.
The government will also provide incentives to certain businesses by providing tax breaks. This is done in some cases to encourage innovation or the growth of new technologies and industries, and, in other cases, it is done to reward groups with strong donors and effective lobbying groups.
The only extent to which federal taxes can be argued to fund spending is in their potential reduction of inflation through removal of cash from the system.
Other than that, the need to find cost savings in tax bills to fund federal cuts is simply foolishness. The premise is incorrect. And, unfortunately, much of the public discourse is informed by incorrect premises, and therefore the strategies used and solutions reached are sub-optimal. With much hard work and luck I hope that will improve.
In contrast to the federal government, state and local governments do not have money-printing power, although they can ask the federal government nicely for federal funds and hope for the best. Because of the lack of state and local money-creation authority, state and local governents do need tax revenues and other receipts from both the public and private sectors to fund their spending.
Fixing the Debt is Super Easy
The debt is the cumulative amount of federal deficit spending and the outstanding public debt. Put another way, it is the total amount of government spending from the date that tracking for this began, minus the total amount of government receipts, plus the total amount of outstanding public bonds (U.S. treasury bonds held by people and entities other than the U.S. government). We won’t worry about the extent of borrowing between U.S. government agencies, and assume this overlaps closely enough with government spending, which is what these intra-agency “loans” are documenting, more or less.
Currently the debt is at approximately $20.5 trillion dollars. A tidy sum.
Is this bad? Well, let’s think about what happens to all this money that the government spends into the economy, or in the case of outstanding bonds, will need to return into the economy with interest.
Whose pocket does government spending end up in? Could it be…the…private sector?
When the government spends into the economy, most of the money goes into health insurance, retirement benefits, national defense, bond payments, education, agriculture, and several other categories. In all of these, the money ends up in the hands of the private sector. It is money the government is giving to us, wihch we then use to purchase goods and services that we need.
Once the government spends that money into the economy, that cash becomes a private asset. Do you want to give all of it back? On an inflation-adjusted basis, government deficits equal private sector surpluses. What the government spends, we save. Now this won’t be a one-for-one for all assets across the board, because there are going to be private sector assets that are not accounted for by government spending, for example assets that were acquired outside the scope of government spending.
Returning to the debt, the government could very easily fix the debt by seizing private assets, defaulting on its bonds, or, while we’re at it, just canceling the bonds. Of course you would never want to to find yourself in this situation, but at least the debt would be cured.
As I mentioned earlier, an issue about the debt that is worth considering is inflation. If the money supply grows too high, we may run out of goods and services to buy with that money. That would be a real problem if you needed healthcare or housing and there just wasn’t any left, although the government could welfare spend an unlimited amount of money into your pocket. This is worth watching out for, but we are far from it, and the Federal Reserve folks are quite astute and are on the lookout exactly for this.
What about China?
Let’s address the point about borrowing money from China because it comes up so frequently that we might as well. First, a question. If the US government has the power to print money for its spending, why would it borrow money, whether from the public or from itself?
The terms borrowing and lending and debt don’t really apply here. They’re from a different paradigm that applies to households and businesses but doesn’t make sense in the context of a government that is a currency-issuer.
An interesting exercise is to consider where the dollars came from in the first place. Where did all the dollars come from? Only the United States can print them, legally at least. The government didn’t borrow its own currency from its own people or the people of China to get started. It’s a currency-issuer and so it had to issue the currency in the first place to kick things off.
When people say we are borrowing from China, what they actually mean without knowing that they mean it, is that China is buying U.S. bonds because it has a large amount of dollars that it receives from trading with the U.S.
That’s all it is. Now the trade deficit that results in this influx of dollars into China and whether that trade deficit is helpful or harmful to either economy involved is beyond the scope of today’s tax discussion.
The point is, we can’t default on our debt to China (just bond payments and repayments), or Japan, or to Americans, unless we choose to stop paying. And that kind of move would remove the dollar from its standing as the world’s reserve currency, because demand for the dollar will evaporate if it turns out our bonds are suddenly worthless. Defaulting on our bonds would also screw all the American savers who hold them and depend on them for their income. Canceling or defaulting on the bonds isn’t an option. The bonds should be viewed more as a benefit that the U.S. confers on the public, rather than as a detriment to the U.S., because interest payments are put into the economy through a stable and reliable instrument, and this injection of funds into the economy by the government is stimulative!
The Current Debate
I hope that the above helps inform your thinking on some of the issues with respect to the current tax reform discourse. Because the currency is already legitimized, we can put that point aside.
What effects would the current tax proposals, if enacted, have on inequality or inflation?
What incentives and disincentives would the proposals, if enacted, put in place?
Let me put forward a couple of ideas on these points, and then let’s take it to the comments for discussion.
The effective corporate tax rate is already quite low, at about 15%. Lowering the top rate will lower the effective rate a bit further. This will definitely enrich executives, owners, and insiders whose compensation packages are tied to business profitability. Will a lower effective rate trickle down into higher wages and lower unemployment? It hasn’t in the past so…
What about helping the majority of folks more directly, rather than taking away deductions that they rely on and hoping for some trickle down effects while definitely enriching those who are already very wealthy?
Why the preference for industries with the strongest donor and lobby groups rather than those that will accelerate our shift to a clean energy future? Or is nuclear truly better for society?
If subsidies are evil when applied to renewables, why aren’t they evil across the board?
What justifies so much inconsistency when it comes to tax breaks?
Why can’t there be more authenticity and critical thinking when discussing these issues?
Note: This post was originally supposed to be entitled “For the Love of God, the Federal Government is not a Household,” but as you can see, it took on a life of its own and went beyond the original topic’s limits.
Buy me a dark roast coffee: