Taxation, Government Spending, & the Free-Market System
The Folly of Fiscal Conservatism, Balanced Budgets, & Flat Taxes
Markets do not exist in a vacuum — they are a product of rules and social order. Markets function only because governments have created a system of institutions and rules that allow them to work. The free market works optimally only within the framework of rules created by government. Government created property titles, courts, police, money, and taxation — all of which are necessary in order for markets to function optimally. Without this governmental backdrop, markets could not exist, much less function efficiently.
The Origins of Money
The classical economic narrative of the origin of money, found in works such as Adam Smith’s Wealth of Nations and Carl Menger’s On the Origins of Money, assumes that people originally traded directly through barter and gradually adopted precious metals as a medium of exchange for the sake of convenience. Gold eventually became the universal medium of exchange because it had an inherent value. Eventually, banks developed as warehouses for people to store gold in and “dollar bills” were issued as warehouse receipts for the gold on store at the bank. Indeed, the term dollar originally designated a specific amount of gold. Over time, people began trading the warehouse receipts themselves in place of the gold. And this was the origin of paper money. While this narrative is quite elegant and seems to be a logically satisfying explanation of the origin of money, archeological evidence and anthropological research have thoroughly disproven this theory. In reality, the earliest forms of money were government-issued and credit-based currencies, not commodity-based mediums of exchange emerging spontaneously from market consensus. While the term dollar did originally designate a certain amount of gold, the “dollar bill” was not actually a warehouse receipt. In reality, the “dollar bill” was just a promissory note representing a credit valued at the amount of a dollar of gold. It was never actually backed by gold.
In, Debt: The First 5,000 Years, David Graeber’s anthropological study of the history of money, it is explained that money historically took two primary forms, either as virtual credit or as metal bullion/coin. The earliest form of money was actually the virtual credit form, while the metallic form came later. In the earliest agrarian societies, money was actually much more like modern “fiat” currency than like so-called commodity money. They would keep records of debts on clay tablets. The money didn’t actually exist but was just a record on a tablet, similar to the way the money in our modern bank accounts doesn’t actually exist but is just a record in a computer. Over time, some of these records actually morphed into tradeable promissory notes, simply specifying that the debt was to be paid “to the bearer” rather than to some specific individual. The use of precious metals for currency first came about when kings had their loyal armies invade and conquer neighboring communities. The soldiers would pillage and loot, taking all the valuable possessions that they could find. Precious metals were commonly used in jewelry that would be stolen from conquered people, so kings would have the metal jewelry melted down and minted into coins. The coins would then be given to the soldiers. The first form of money to arise was the virtual credit form, which arose in relatively peaceful agrarian societies. The second form, metallic money, arose later in history with the emergence of warring city-states that would plunder neighboring communities. Modern money systems are actually a mixture of these two forms. Modern money combines both virtual credits created by private loans and government-issued currency.
You may be thinking, “Well, what about the gold standard?” There never was a “gold standard” such as the one we learned about in school. In Milton Friedman’s words, for most of the gold standard era the United States “though ostensibly on a gold standard…actually was on a fiat standard combined with a government program for pegging the price of gold.”(Milton Friedman, Money Mischief: Episodes in Monetary History, Ch. 10) The government kept a reserve of gold, but it was never anywhere near enough to redeem the whole money supply. With the “gold standard,” there were fixed international exchange rates and a price-specie-flow mechanism to automatically correct trade imbalances between nations. This balance-of-payments adjustment mechanism was actually the primary function of gold under the gold standard. The idea that the dollar was backed by gold under the gold standard is fundamentally a misunderstanding. Under the gold standard, government created a fixed exchange rate between the dollar and gold — the Coinage Act of 1873 and the Gold Standard Act of 1900 artificially pegged the dollar to a specific amount of gold. (The Gold Standard Act set the exchange rate at roughly $20.67 to 1 Troy ounce of gold.) The dollar was never backed by gold, but merely arbitrarily pegged to it. The dollar is a promissory note to pay in the future (e.g. a debt), not a warehouse receipt of some sort. When the government originally issued currency, it didn’t say “Here’s a receipt for so-much gold;” it said, “We don’t have enough gold to pay you right now, so here’s an IOU.” These IOUs, in theory, were for an amount of gold, but gold naturally fluctuates in value and so do paper notes when used as currency. The dollar bills would be traded and have their own market value independent of the market value of gold. When we were on the “gold standard,” a certain amount of gold was used as a unit of account and artificially pegged to the dollar — government price fixing! It was an attempt to keep the value of money stable by government decree as if by magic. It didn’t work, which is why we ended up having to abandon the gold standard.
The United States never really had a gold standard in the sense that most people imagine; and, prior to the late 19th Century, we actually had a de facto silver standard. The U.S. Constitution (Article 1, § 10) says, “No State shall…make any Thing but gold and silver Coin a Tender in Payment of Debts.” This left open the possibility of the Federal Government changing the currency system or issuing fiat paper money, but it also set us on the course for bimetallism. The American monetary system, prior to the late 19th Century, was not a gold standard but a bimetallist system in which gold and silver were equally regarded as legal tender. Upon Alexander Hamilton’s recommendation, the legal tender exchange rate was set at “15 times as much for an ounce of gold as for an ounce of silver, whence the ratio of 15 to 1.”(Cf. Milton Friedman, Money Mischief: Episodes in Monetary History, Ch. 3) However, by the end of the 1700s, the market value of gold relative to silver changed. Consequently, gold could not feasibly be used as legal tender anymore. “But shortly [after 1792] the world price ratio went above 15 to 1 and stayed there (see Jastram1981, pp.63–69). As a result, anyone who had gold and wanted to convert it to money could do better by first exchanging the gold for silver at the market ratio and then taking the silver to the mint, rather than taking the gold directly to the mint.”(ibid.) In effect, silver ended up being the only metal actually used as currency until 1834. This episode in monetary history demonstrates that even precious metals are not stable and the price level would fluctuate, even on a gold standard, unless steps were taken to stabilize the price level through regulation of some sort. Inflation and deflation will result from any change in supply and demand; and the supply of as well as demand for precious metals will change if new mines open up, if new non-monetary uses are discovered, etc. The bimetallist system instituted by the Founding Fathers functioned by allowing consumers and bankers to switch between a de facto silver standard and a de facto gold standard based on market prices of the metals.
The inherent instability of price levels on a metal standard resulted in people preferring the paper notes of the Bank of the United States as a medium of exchange. When Andrew Jackson and his cohorts sought to bring down the Bank of the United States, all they had to do was pass legislation to make the Bank of the United States accept gold as a substitute for its notes at the legally established ratio that differed from the actual market rate. The Bank had only really been giving silver (one of the two legal tenders) in exchange for its notes because the market price of gold was much higher than the monetary value of gold artificially set through legislation. As a result, forcing the Bank to give gold (rather than silver) in exchange for its notes ensured that the Bank would fail. The central bank ended up being abolished as a result.
Eventually, more gold was discovered in California and in Australia, devaluing gold relative to silver. This resulted in the market changing its preference from silver to gold as the standard medium of exchange. This led to the emergence of the so-called “gold standard.” But the gold standard never really was a gold standard. Banknotes were always in use and these notes tended to have a market value independent of the value of the amount of gold that they were supposed to be pegged to. The Coinage Act of 1873 ended bimetallism and effectively put us legally on a gold standard. This proved to be a terrible decision. As the mines started to “dry up” and the supply of gold stopped increasing, sharp deflation followed, which resulted in an economic depression by the time William Jennings Bryan was running for President in the mid-1890s.
Classical and Austrian School economists tell us that the modern banking system has a fraudulent basis. Banks were supposed to be gold warehouses, but the practice of fractional-reserve banking led to the creation of more gold receipts than actual gold. This caused the dollar bills to be devalued relative to gold, which created instability and led to the collapse of the gold standard. In this narrative, it is falsely assumed that gold backs the currency and that the dollar bill is a redeemable warehouse receipt. The classical and Austrian School economists considered the bankers to be committing fraud because they were telling people that they could redeem these receipts even though the bank didn’t actually have enough gold to redeem them if everyone came to redeem them at once. The reality, however, is that the dollar was never advertised as a warehouse receipt. It has always been a promissory note or IOU from the government or from a bank. When I take out a $500 loan and promise to pay it back, my promise to pay it back does not imply that I currently have the funds to do so. It only assumes that I have the capacity to acquire the funds and pay off the debt at a future time. There is no fraud here if you actually understand what is going on.
How Monetary Systems Work
Money is created by governments. A dollar is an IOU from the government, a credit token, which the government promises to accept as payment for its services. Governments create money by spending it into existence. Money is analogous to subway tokens. The municipality accepts its own subway tokens as payment for a ride on its subway train. However, before they can accept subway tokens as payment, they must first issue those tokens. They first create the tokens, giving them out to people, then collect them back in exchange for their services. National governments do the same thing with money. Governments first created money and gave it out to the people, then later collected it back in exchange for their services. If there are 200 people who need to use the subway this morning, and the train has the capacity to carry that many people, but there are currently only 50 tokens in existence, then the municipality needs to increase the supply of tokens in order to meet the demand. As long as there is room on the train for all the people that want tokens, the subway can create more tokens without it devaluing the tokens. They will simply create an additional 150 tokens and sell them for the same price as the existing tokens. Likewise, a government must supply enough money to meet aggregate demand; and, as long as the increase in supply does not exceed the capacity of the economy to meet the demands of consumers, there will be no inflation. The subway issuing new tokens will not devalue the tokens unless they issue more tokens than they have the capacity to honor.
If, however, the subway train only has the capacity to transport 300 people and there are 600 people needing to ride the train at the moment, it does little good to just print 600 tokens. The additional tokens will now just devalue the tokens overall. Each person will now only have a 50% chance of being able to redeem their token in exchange for a ride on the train, which means that the real value of the tokens is half of what it was when a token gave one a 100%-guarantee of access to the train. In this scenario, half the tokens would be worthless, so the people that need access to the train most and have the most resources available at their disposal would scramble to buy up more tokens so that they could secure their place on the train. And, in all probability, the subway station would end up raising their price to 2 tokens per 1 ride. By increasing the supply beyond the capacity of the subway to honor the tokens at their current value, they have actually devalued the tokens. Likewise, government can simply print more dollars (credit tokens) to meet the demand of consumers as long as the economy has the capacity to meet the demand of consumers. This will cause no inflation, just as creating new tokens for subway rides causes no inflation as long as the subway has the capacity to let all the people ride on the train. However, if the economy does not have the resources to meet the demand of consumers and the government prints more money, the dollar will lose some of its value. The constraint on how much money the government can spend into existence without it causing inflation is not how much revenue it can bring in through taxation. The only real limit on the government’s capacity to spend without causing inflation is real resource availability.
Conventional wisdom tells us that government must first tax the people before it can spend. This is false. Government must first spend before it can tax. This is because government spending is the mechanism through which money is created. If government does not first spend money into existence, there will be no money for it to take back in taxes. The term revenue literally means “that which has been returned” — it is that portion of the money that government has created which has now been returned to the treasury. The government does not spend tax revenue. This is because taxation and spending are both monetary policies. Government creates money by spending it into existence, thereby expanding the money supply. Government removes some of the money from circulation, thereby contracting the money supply, via taxation. These are two of the mechanisms through which government can regulate the supply of money. The government must constantly be collecting and issuing money, just as the municipality must sometimes issue new subway tokens and sometimes collect tokens and remove them from circulation. Sometimes tokens are lost, deflating the supply, so the municipality will have to counteract this by creating new tokens to reinflate the supply. If there is an excess of demand for public transit and the subway expands to increase its capacity to transport people, the municipality will need to issue new tokens to meet the demand up to the level of the train’s capacity to meet that demand, but not beyond that point. So, too, the government must increase the money supply by spending more money into existence if the economy grows and real resource availability increases. If the government does not do so, then there will be “too many hands chasing too few dollar bills” — there will not be enough money to meet the capacity of the economy and demand of consumers. If government refuses to spend more money into existence at this point, this will result in a recession. There will not be enough money in existence for the people to purchase the goods and services that are available, resulting in a general glut, where the goods produced by society will not be bought up by consumers. During a recession, there is a disequilibrium of supply and demand — there is not enough demand to clear the market. If the deficiency in demand is simply a result of a lack of money (e.g. if the only reason people aren’t buying the excess products is because they don’t have enough money to do so), then government simply needs to spend more money into existence in order to rectify this problem.
This is why fiscal conservatism makes no sense at all. Every dollar bill is a credit token from the government and credit is debt! What is a credit to the private sector is a debit to the public sector. It is an IOU from government which they promise to accept back as payment for their services. If the government pays off all of its debt, there will be no money in existence. Not having a national debt means not having a monetary system — the abolition of the market economy! Not only is paying off the federal debt absurd but so is the idea of a balanced budget. If the government does not run a deficit, that means no new money is being created. If government spending does not exceed what is collected back via taxation, the economy cannot possibly grow. A balanced budget prevents the economy from being able to operate at full capacity. For the economy to grow, government must spend in excess of what it generates in revenue in order to supply the people with enough currency to purchase the resources that are actually available. As long as the economy is not operating at full capacity, using up all the real resources available, government does not need to collect taxes in order to be able to spend. Government only needs to use taxation to offset spending if it is spending more money into existence than can be readily redeemed in real resources. The constraint on government spending is not revenue but rather real resource availability.
To better make my point here, let’s do some Crusoe economics. Suppose that there are two people, Bill and Sue, stranded on a desert island. They quickly find that direct trade is inconvenient and doesn’t really work. Bill gardens in the summer and collects fruits from a nearby forest whenever the weather permits. Sue, on the other hand, raises livestock for meat. In the summer, Bill has access to all the fruits and vegetables that he needs, and Sue will occasionally trade an animal for a certain amount of vegetables. When the winter comes, Bill can’t garden or forage for fruits. He goes to Sue and asks for some meat to feed himself. So, Sue decides to give Bill some food and let him pay her back later. They decide to create a spreadsheet so that they can keep track of who owes what to whom. They decide to measure value in bushels of grain, reckoning that 1 bushel is worth 1 chicken, 4 bushels are worth one pig, and so on. She gives Bill 1 chicken and 1 pig. The spreadsheet appears as follows.
In this scenario, Bill is going into debt and promising to pay Sue back later. Their accounts were originally both at zero, with no credits or debits in either account. After the transaction, Bill has 5 bushels debited from his account and Sue has 5 bushels credited to hers. The credits function as currency. Let’s assume that they even create little 1-bushel promissory notes to correspond to the credits in Sue’s account. She now has 5 bushels worth of promissory notes that she can take back to Bill and use to trade for 5 bushels of grain later on. In this case, Bill has effectively created money or issued currency by going into debt. Spending and income are the exact same thing, but looked at from different perspectives. Bill’s spending is Sue’s income. You’ll notice that there is an accounting identity here. If you look at all the accounts collectively, the debits in one account are cancelled out by the credits in another— and the two accounts balance to zero overall. If the total supply of money or credits is 5, then the total amount of debt in this miniature economy is also 5. If all debts are eliminated, then so are all credits. If both parties insist on keeping a balanced budget, then the monetary system is dissolved.
In the modern world, however, we know that the government (through its Treasury and Central Bank) is the sovereign issuer of currency. For the sake of simplicity, we will temporarily ignore money as private debt and focus just on government-issued money. A newly created government decides to create a monetary system, so it spends $1 million into existence. However, fiscal conservatives immediately come to power and decide that they want to balance the budget and pay off the national debt. This development plays out as follows:
In order for the private sector to have money, the public sector must be in debt. For the public sector to keep a balanced budget and have no debt, the private sector must have no money. When there is a money supply of $1 million, government has a debt of $1 million, corresponding to the private sector’s surplus of $1 million. When the fiscal conservatives get into power and decide to pay off the debt, they have to collect $1 million from the private sector to pay off the debt of the public sector. In doing so, they destroy all the money in existence and end up inadvertently abolishing the market system.
The government has taxed away every single dollar from the private sector in order to pay off the national debt. Suppose, however, that the government does not just balance its budget but also runs a surplus. Now, one may be inclined to think that a government just can’t possibly run a surplus. In reality, our explanation thus far has been oversimplified. Do not forget that we chose to temporarily ignore private money creation through private debt. In reality, private debt between individuals is still a thing. Private individuals are sometimes untrustworthy, so private debt is usually monetized through the medium of banking institutions that the people trust. These banking institutions are backed by the government. Banks create money when they give out loans, but the sovereign monetary authority is in the hands of the State. Money is debt and a bank can create money by giving out a loan since the government permits it to do so.
Let’s imagine that the government from our previous example decides it wants to run a surplus after it pays off its debt. Having balanced its budget by collecting back the whole money supply through taxation, the government decides it wants to accumulate a surplus of funds by further taxing the private sector. So, it collects an additional $1 million in taxes. “Wait! It can’t do that because there is no money!” Well, in this scenario, people have to take out loans to pay their taxes. When you take out a loan, the bank credits money to your account and debits its own account. Now, the scenario is a bit more complex and looks like this:
In order for people to have enough money to pay their taxes under these conditions, money must be created through private sector debt. When the people take out loans to pay their taxes, private individuals’ accounts are credited with $1 million as the banks’ accounts are debited $1 million. This scenario with government running a surplus is quite precarious because it creates economic instability. The private sector is running on debt. Keep in mind that the $1 million deposited to private individuals’ accounts was a loan — it must be paid back. How are the people going to pay off their loans? Well, either government has to spend money back into the economy to allow private individuals to pay off their loans or the people must borrow more money to make payments on their existing debt. The latter scenario is absurd and unsustainable. In demanding that the government do public finances the way private individuals ideally ought to run their household finances, the fiscal conservative guarantees that private households cannot be financially responsible!
The above example is accurate but unrealistic. We have again oversimplified things for educational purposes. The real world is way more complicated than this. It is entirely possible for government to run a surplus and for some individuals in the private sector to also run a surplus. Some households can be financially responsible and stable, but they cannot all be responsible and stable. In the aggregate, or collectively, the level of financial irresponsibility and instability in the private sector under fiscally conservative public finances must be such that it creates economic instability overall! The aggregate balance of the private sector as a whole must be in the red in order for the government to run a surplus. Yet, we have only been focusing thus far on people being able to pay their taxes. We have not even considered the level of debt that would be needed in order for people to survive. In reality, people wouldn’t just borrow enough money to pay their taxes. They would also borrow enough to buy houses and cars. The total amount lent out by the banks would not be equivalent to the total surplus carried by the public sector. The following is a more realistic scenario:
Notice that in order for private individuals to have enough money to live on, the private banks are forced to lend out much more than the amount of the government surplus. And, the private banks have to lend out money they don’t have. In reality, the government is shirking its responsibility as the sovereign monetary authority and forcing the private banks to do its job for it. The private banks have far less capacity to do this than the government does and it creates too much instability when the private banks have to do this. Keep in mind that all of the credits in private individual accounts in this example actually originated from loans. While we see a positive balance in private individual accounts overall, those assets are offset by liabilities. The loans have to be paid off. Plus, it would only be possible for the private individuals to pay off the principal plus interest on their loans if the private banks continually give out more loans, leading to constant and exponential growth of private sector debt.
In order to be truly financially responsible, given macroeconomic realities, the government needs to have a substantial amount of debt and run a significant deficit. If the government does not do this, it forces the private sector to carry those burdens. The private sector cannot carry those burdens for very long without it resulting in economic instability.
To drive home this point (that fiscal conservatism is a terrible idea), let’s do another exercise in Crusoe economics. If a sovereign money-issuing country pursues a fiscally conservative approach, it will always lead either to an economic recession or economic instability as private individuals become overburdened with debt.
Suppose a ship wrecks on a desert island, stranding a crew of 22 people. After a while, two of the members of the crew create their own businesses doing some sort of manufacturing. Let’s call the businessmen Sam and Walter. Sam and Walter will both, of course, incur costs associated with running the businesses. Let’s say that they purchase some supplies and materials from the other crew members. They decide to use “chickens” as a unit of measurement for accounting, with one credit being equal to the value of one chicken, and they issue IOUs to cover the cost of the supplies they must purchase. They each go into debt by issuing 500 chickens-worth of IOUs. The result can be shown as follows:
The two businessmen have created money by going into debt. Now that they bought their supplies, they will also need workers to help pump out the final product. So, they both issue additional IOUs in order to pay wages. They each hire ten workers and agree to pay them five chicken-credits per week. After three months, their final product is ready to sell. The balances of debt/credits now looks like this:
The total cost of production was 2200 chicken-credits. The total supply of money also happens to be exactly 2200 chicken-credits. Therefore, the manufacturer can only sell at a market-clearing price if he sells his product at cost of production. However, this is not how markets work. Businesses always try to make a profit by selling at a markup. This strategy is called cost-plus pricing or markup pricing. The business will sell at a price with a markup of a certain percentage above the cost of production. Since people tend to value final products somewhat more than the value of all materials and labor that went into producing them, sellers are easily able to markup the price in order to bring home a profit. Value is subjective and the value to consumers always differs from the cost of production.
Let’s assume that they markup the price by 10%. It costs 2200 chicken-credits to produce the total supply. The amount that would have to be spent on the product to clear the market, with the markup, is now 2420 chicken-credits. However, the total money supply is only 2200 chicken credits. The total money supply will always be equal to the total amount of debt. The businesses are demanding more than all the money in the world for their products!
The problem that we have run into is that there is not enough money in existence to allow the market to clear at a price that allows the businessmen to make a profit. Nevertheless, people do subjectively value the product higher than the cost of production, so they are willing, initially, at least, to purchase it at cost plus markup. When the workers start purchasing the product, the money goes back to Sam and Walter, canceling out their debts. And, since their IOUs are money, the money supply shrinks to zero.
However, even in exhausting the whole money supply, the market was still unable to clear. The original money supply was 2200 chicken-credits and the amount needed to clear the market is 2420 chicken-credits. Spending every single unit of currency is not sufficient to clear the market. We can illustrate what happens with the following chart:
In order to clear markets, someone must go into debt for that additional 220 chicken-credits. If no one goes into debt in order to purchase the remaining supply and clear the market, then a recession sets in and we witness a disequilibrium of supply and demand.
This illustration demonstrates the principle, but we should also note that this problem gets much worse when you have many more producers than just a couple of companies. The result is that the level of debt has to keep rising indefinitely or else the economy will collapse. In ancient Mesopotamia, they remedied this problem with periodic debt cancellations. In the case of modern economies, they remedy this problem by transferring the duty of issuing currency to a sovereign power. Thus, the government takes over the role of issuing the IOUs/money to be used as a medium of exchange. The rationale behind this is that the government can usually issue the additional IOUs needed to allow the market to clear without it causing any problems, whereas private-sector debt can easily get out of hand. The use of private-sector debt to supply the credit/money needed for markets to function optimally results in an ever-increasing amount of debt held by private individuals, burdening the populace and creating instability. Additionally, loans usually have interest associated with them. Interest is akin to profit. The amount of money created by the loan does not cover the interest, so a shortfall will result there too in the final analysis.
Let’s do another Crusoe econ type illustration to demonstrate this point about interest. Assume that there are only two individuals in the world. The one issues IOUs to the other, extending credit to them, but charges 2% interest on that loan. For simplicity’s sake, we’ll say that 2% on the total amount is what is due upon repayment. The following chart illustrates the situation:
There is not enough money in existence to cover principal plus interest, just as there was not enough money in existence to pay cost plus markup. These two problems are what inspired social reformers like Josiah Warren and C. H. Douglas to propose things like the “cost principle” and “social credit.”
The best solution is to have the bulk of money issued by a sovereign money-issuer (e.g. government). Instead of lending the money into existence, the government can simply spend it into existence. When public works projects need to be done, the government issues the IOUs to pay for it. Those IOUs then circulate as money. The problems associated with profits and interest that we saw with private-sector creation of money simply don’t occur. Moreover, such a currency system can allow for profit and interest to exist without it causing economic instability. The government just has to spend enough money into existence to allow for profit and interest in the private sector. The government can do this by spending money on various things — e.g. road maintenance, welfare provisions, space exploration, grants, paying wages to government employees, etc. This is the only way to have a stable market system. Of course, this means that no sound economic system can exist under a government that pursues a fiscally conservative spending policy.
If a government wanted to pursue a fiscally conservative policy, the only way it could do this without creating economic instability is by mandating that all businesses sell their products at cost of production. This would be something akin to Josiah Warren’s experiments with making “cost the limit of price.” They would also have to reform banking and prohibit usury or the charging of interest. Libertarian socialists in the tradition of Josiah Warren and Benjamin Tucker sought to eliminate profit, interest, and rent. Such a thing could be done in a non-anarchistic framework if a modern government wanted to be fiscally conservative. In order to keep from having to constantly spend more money into existence, the government could ban profit, interest, and rent. However, this would have serious unintended consequences. The Spanish anarchists ran into problems when they made producers sell at cost of production. Speculators would normally have bought up grain after harvest and stored it away to sell with a markup later. Since markup was prohibited, no one did this. The result was that the supply ran out and a famine resulted in the winter months.
Setting the price at the cost of production also interferes with price signals. Value is subjective and that subjective value is reflecting in the amount that people are willing to spend on things. The difference between cost of production and the sale price is the profit margin but it is also a direct result of the difference between the concrete value in terms of cost of production and the subjective value in the minds of consumers. If people are willing to buy something at a higher price, that price signal tells producers that it is worth producing more of it. If people are not willing to buy at the cost plus markup, it indicates that perhaps the producer should slow or halt the production of that product. Interfering with such price signals by prohibiting profit would ruin the market as a distribution mechanism. It would, then, be pointless to insist upon having money or a market at all. We conclude that fiscal conservatism is everywhere and always antagonistic to market processes.
The Function of Taxation
The three primary functions of taxation are: (1) to give rise to, or sustain, markets by establishing a demand for money, (2) to offset inflation caused by excess spending if necessary, and (3) to discourage socially harmful behavior.
Money as we know it first came into being when kings issued it to their soldiers as payment. Some king invades a new territory and conquers its people. He pays his soldiers in his own sovereign currency. However, that payment does little good if the soldiers can’t spend their money. So he also demands tribute from the conquered people, mandating that this tax is payable only in the king’s own sovereign currency. Since the new subjects must pay this tax on pain of death, the tax establishes the demand for the currency. Suddenly the people are eager to get the king’s money since they need it to pay their taxes — so the taxation establishes a demand for the currency and encourages the people to start trading their real resources with the soldiers in exchange for the king’s money. This gives rise to a market.
It is true that ancient sovereign money systems involved metallic coins, but this should not be mistaken for the metals themselves being money per se. When a king had coins minted and spent them into the economy by paying his soldiers, he was basically issuing those coins as credit tokens. The king was functionally issuing them as promissory tokens that he would accept back in payment for his own services (e.g. protection) — the king was essentially running a protection racket and lending people the money so that they could pay tribute to him. The metal coins had the benefit of also having a use value independent of their money value, which did create an extra incentive for people to accept them in exchange for goods, but it was not necessary for the king to use metal as long as he used coercion and the threat of violence (that is, taxation) to establish the demand for the money. The reason that metal began to be used for coinage was because (1) war and plunder had given kings a large supply of metals and (2) the alternative materials from which money could be made (e.g. papyrus, clay tablets, etc.) were costly to procure in large quantities and easy to counterfeit. The average person could easily get a clay tablet and engrave it so that it looks like one of the kings promissory notes, but the average person did not have the means to melt down precious metals and mint coins that could easily pass for the king’s money. The minting of coins with the king’s face on it, therefore, functioned analogously to the way watermarks are used on modern paper money — they made it hard to counterfeit.
The coins were not really the “commodity money” of classical economic mythology. The value of the king’s money, though made of gold, was never equal to the value of the gold that it was made of. Sometimes the use value of gold was more than the money value, so people would melt down their gold coins and sell it as bullion. At other times, the money value was greater than the gold it contained. The disparity between the use value of the coins as metal and their money value was always there, regardless of whether or not the king devalued the coin by reducing the amount of metal contained in it. Alterations of the size, weight, and composition of the coins didn’t create the disparity but merely exacerbated it. Suppose that a kingdom has a total population of 100 taxable subjects and 20 tax-exempt soldiers. The king issues 80 gold coins and gives them out to his soldiers. Then the king demands that every single taxable subject pay him 1 such coin in tribute on pain of death. If you fail to pay the tax, you will be executed. Now, the tax obligation for each person is 1 coin but the supply of the king’s sovereign money tokens is not large enough for everyone to be able to pay their taxes. The scarcity of the king’s coin here — and the fact that the tax payment can only be made in the king’s official coin — will cause people to scramble for access to those coins. If you acquire pure gold bullion, it does you no good because you will still be executed if you cannot pay your tax bill in the sovereign currency. Consequently, there will be more demand for the king’s money than for an equal amount of unminted precious metals. The soldier will be able to trade his special coins for much more than the value of the metal of which it is composed. Thus, it was never really precious metals that gave money its value — the value of money has always had far more to do with government policy than with any inherent quality of the material form that money takes.
Spending and taxing on the part of government are necessary but not sufficient to create and maintain market systems. To ensure that markets function adequately the government also needs to establish a system of laws governing property rights and contracts. In a state of nature, there are no titles or deeds to land. A person may have possessions in a “state of nature” (i.e. in the absence of government), but they cannot have property. Property refers not just to possessions but to legal possession and the rights associated with such possession by law and custom. Government creates titles to land, which allows people to use their homes as collateral for loans. A toothbrush is a mere possession, while a house is property proper! Government creates a system of law, courts, and police to enforce the rules. This allows people to take out loans and use their home, business, etc. as collateral. This allows people to make formal written contracts that will actually be binding and enforceable. Government creates the framework for markets. That framework includes such institutions as law, courts, police, and money. Taxation is a key component of the monetary institution, without which markets could not function.
Although taxation is not needed to fund government spending, it can be used to offset government spending if excess spending causes inflation. Suppose that the money supply is sufficient for the economy to operate optimally at its current capacity. However, the nation suddenly gets invaded by a hostile neighbor. Even though the money supply is already at the optimum level, the government still needs to spend more in order to protect its citizens from these foreign invaders. Unfortunately, this additional spending will inflate the money supply beyond the optimum level and, thereby, devalue the currency. In order to keep this new spending from devaluing the currency, the government must offset that spending. There are several ways that the government can do this, but the most obvious way is to simply collect more taxes on the other end in order to shrink the money supply proportionally to the increase on the front end. In this scenario, someone somewhere will have to make a sacrifice and give up a little more in taxes so that the needs of the society can be adequately met. In industrialized nations like the United States, situations in which government runs into this real resource constraint and is forced to spend while offsetting with taxation are exceedingly rare. Taxation as a tool for offsetting inflation — which would be functionally analogous to government using taxes to fund spending, even though taxation doesn’t technically fund spending — is actually a lesser function of taxation, since the government does not need to do this under normal circumstances.
The final function of taxation is to discourage socially harmful behavior and, thereby, encourage markets to function optimally. This is the function of taxation that I find most interesting. The vulgar libertarian conviction that markets naturally and spontaneously produce optimal results is bogus. Government is the real invisible hand that causes optimal results to emerge from individuals acting in their own self-interest within a market economy. Without government, it would occasionally be in my best interest to steal and violate contracts; but government creates the institutions of justice that ensure that it is not in my best interest to steal or break my contractual obligations. Without government, it might be in my best interest to dump toxic waste in the river since that is the easiest and cheapest way to dispose of it; but the government imposes penalties for such socially harmful behavior in order to encourage me to do the right thing. The invisible hand that guides markets towards utopia is strong government and good policy. The only reason your workplace is relatively safe, your wages are sufficient to live on, and the air quality in the streets doesn’t kill you is because of governmental institutions and policies that make markets function to the benefit of everyone. Our employers would really rather pay us starvation wages and cut corners on safety measures in the workplace in order to maximize their own profits, but minimum wage laws and OSHA regulations prevent them from doing so. Car manufacturers would really rather maximize their profits by not putting catalytic converters on every car, but the Clean Air Act requires manufacturers to put catalytic converters on every car because this device filters out toxic chemicals in the exhaust fumes that are harmful to people’s health. The vulgar libertarian ideal of unregulated markets would really result in a dystopia in which workers are impoverished nigh to the point of starvation while pollution renders the air and water unsafe to come into contact with.
Within a market system, it is best if the government regulates things in the most uniform and least invasive way possible. This is where Pigouvian taxes come in. A Pigouvian tax is a tax on behaviors that are socially harmful. The purpose of the tax is to discourage socially harmful behaviors. Suppose that sulfur dioxide emissions are causing excessive acid rain. The acid rain is destroying crops and causing numerous economic problems. In an effort to reduce acid rain, the government can impose an emissions tax on sulfur dioxide. Suddenly, it costs companies more money to pollute, which encourages corporations to pollute less. As a result, corporations will change their behavior in order to save money — some of them will shift to more eco-friendly ways to conduct their business. This, in fact, is not theoretical at all. This is actually what happened when the United States imposed an emissions tax to reduce the amount of acid rain under George H. W. Bush. This is why we don’t hear a lot about acid rain in the news these days — because it’s not such a big problem now that emissions taxes have effectively forced companies to stop emitting so much sulfur dioxide into the atmosphere! Since taxation is necessary in order for a market to function at all, it would be pretty idiotic to not design our tax system in a way that encourages corporations and individuals to behave in a socially beneficial manner. On the one hand, taxation’s primary function is creating and maintaining demand for the currency, which is a prerequisite for markets to operate at all; on the other hand — in its secondary, Pigouvian function — taxation goes further and helps to ensure that markets function in the most optimal way possible.
“ We need more Tax Positivity on the left. Taxes come in all shapes and sizes, and they’re all beautiful. Some are better than others depending on context, but none of them are mutually exclusive…. Have you told a tax it’s beautiful today?” — James Medlock
How Shall We Then Tax?
Since taxation creates and maintains the demand for the currency, it is necessary for the level of taxation to be substantial. If you only impose a small tax on a few, it will only create demand for the currency among those particular individuals. This will not be enough to foster the emergence of a market system. Even with a market system already in place, you can’t reduce taxation to the point where only a minority of individuals have to pay any taxes. If you were to reduce taxation to the point where only a minority of individuals had to pay anything, it would lead to the disintegration of the market system. If most people don’t need the government’s money to pay their taxes, they will start using other things as a store of value or medium of exchange — they may start saving gold and silver and using cryptocurrency for trade. It is the government’s money as a universal medium of exchange that has integrated all trade into a unified market; so when the government’s money ceases to be the universal medium of exchange, the market will start disintegrating. Over time, the market will deteriorate and fall apart. If there is no single money that all people use, it becomes more difficult to facilitate exchanges. This makes doing business much more complicated and costly. The market system, characterized by the cash nexus, will decay into a barter economy. Barter economies are naturally less efficient and cannot be industrialized, so social wellbeing will decline. In order to create sufficient demand to foster reasonably functioning markets, you need the scope of tax to be widespread — this will induce demand for money amongst the majority of the population. However, you also need the scale of the tax to be sufficiently large. If you collect taxes from everyone but only collect a small amount, there will be universal demand for the currency but the level of demand will be low, such that the demand created does not lead to the emergence/continuance of a market system. In order to foster markets, a substantial proportion of transactions need to be transfers back to the treasury (payment of taxes) and the distribution of these transfers needs to be fairly widespread.
At first, one may think that a flat head tax might be a reasonable and equitable proposal. However, this is not the case because real economies are unequal — the distribution of wealth and money from the outset is such that the imposition of a flat tax would be unjust. To tax everyone uniformly and evenly is to impose an unequal distribution of the tax burden. To illustrate this point, let’s delve into some simple Crusoe economics. A group of five individuals is stranded on a desert island and decides to create their own society and their own currency system. After people have had some time to make trades, save, and spend a bit — such that the distribution of wealth has become unequal — , let’s suppose that this society decides to introduce a flat head tax and charges each individual $2. We end up with something like the distribution of money and taxes seen below. You’ll notice that the ratio of each person’s share of wealth relative to their share of the taxes is not even. This means that each individual’s tax burden is different, even though their tax amount is identical.
Suppose that the cost of living is $4.50, so that any level of taxation that reduces a person’s share of money to less than that amount would deprive that individual of access to food, shelter, water, or some other necessity. In this example, we see that persons 2 and 3 have both been reduced below this level by the tax — they have been impoverished by a heavy tax burden! Yet, the inconvenience of this tax upon person 1 is very mild in comparison — he has a very small tax burden. The burden of this tax deprives two people of access to necessities while leaving another individual in such a position that he can still meet all of his needs ten times over.
I have used a simple Crusoe economics example to illustrate this point, but it is easy to see how what we learned here would apply to the real world and to more complex situations. One might suspect that we could rectify this problem by replacing the flat tax amount with a flat tax rate. This, however, does not solve our problem. The chart below illustrates this by showing what happens when we take 5 individuals with various incomes and impose a flat tax rate upon their incomes.
To calculate the total necessary expenses for this scenario, I have posited that in the hypothetical society in question the average person has a mortgage of $400 per month, spends $200 per month on car maintenance, fuel, and insurance, and spends $100 per month on food, bringing their total necessary spending up to $700 per month or $8,400 per year. You’ll notice that under a flat 20% income tax, person 1 is totally impoverished. In the end, he comes up $400 short so that his income after taxes is insufficient to meet the bare essentials. Person 1 has an excessive tax burden that ruins his finances. Person 5, though he is still able to cover the ordinary essential spending, is now left with very little disposable income. If he runs into any unexpected expense or emergency, he too will fall short of being able to meet his needs. The tax burden for persons 1 and 5 is so excessive that neither of them will have any disposable income left for luxury or recreation. Meanwhile, the other individuals can still meet their needs with their remaining income after taxes and have plenty of money left over to indulge in the pursuit of happiness. The burden of taxation is still unequal and the fact that the tax system would impoverish some while allowing others to live in luxury is clearly unjust!
How can we solve this problem? Well, we can transform this income tax into a differential tax in order to make it progressive. Hillaire Belloc explains it as follows:
“The principle of the Differential Tax is that a different proportion of taxation, as well as a different amount, may be applied to men in different circumstances. For instance, if you apply an income tax of zero to incomes under $2,000, of 5 per cent between $2,000 and $5,000 of 10 per cent between $5,000 and so on, that is a differential tax. Or again, if you charge an amount of $5 for taking out one license for a particular purpose, $15 for taking out two licenses, $50 for taking out three, and so on, you are applying a differential tax to licenses.”
In practice, this may mean that we establish different tax brackets and charge people in different brackets different rates, such that the wealthy pay a higher rate than the poor. To turn our flat income tax from the previous chart into a progressive income tax, we will create 4 tax brackets and reduce the tax rates for everyone earning less than $100,000 per year. At the same time, we will increase the tax rate by 1% for anyone making over a million dollars a year. The tax brackets and rates shall be as follows:
When we apply these rates to the chart from the previous example, transforming our flat tax into a progressive tax, our new chart looks like this:
In terms of the burden of taxation, this new arrangement seems far more just and reasonable. By reducing the tax rate for the lowest-income individuals, we ensure that taxes do not impoverish anyone. Also, notice here that we only increased the taxes for the highest-income individuals by a mere 1%; and, that this slightly higher rate only applies to one person. Nevertheless, even though we have cut taxes substantially for the poorest individuals in order to avoid impoverishing them, our new tax system actually brings in more revenue in spite of the fact that our top tax bracket only saw a 1% tax increase compared to the previous scenario. Under this progressive income tax system, the distribution of the burden of taxation is much more just and fair. Progressive taxation is not only more just: it also captures more revenue.
What About Doing Generous Transfers Alongside A Flat Tax?
A recent Efficient Redistribution policy paper has caused many policy wonks to come out in favor of a more broad-based and flat tax scheme. It is a fact that flat taxes can be rendered more progressive by more robust transfer schemes. In terms of income distribution, subsidizing people with lower incomes is more progressive than merely taxing people with higher incomes at a higher rate.
The paper in question concluded: “Though it is optimal to tax wealth and to allow marginal income taxes to increase with income, a flat tax levied uniformly on both labor and capital income achieves almost all of the welfare gains attainable using more complex instruments.”(Corina Boar and Virgiliu Midrigan, Efficient Redistribution) The case that they make is that you run up against diminishing returns with pursuing a more progressive tax scheme. The marginal utility of making the tax scheme more progressive relative to the welfare gains that would result from more progressive taxation is relatively low. “Overall, we find that an optimally chosen flat income tax delivers the bulk (80%) of the welfare gains that can be achieved with more complex income and wealth taxes.”(ibid.)
I agree with their research, methodology, and conclusion. However, I would point out that we already have a more progressive tax scheme in America, so we don’t need to talk about the diminishing returns of switching from high transfers with flat taxes to a progressive income tax system. If you were looking at a European welfare state with relatively flat taxes alongside a robust system of transfers, then I would concede that the marginal utility of making taxation more progressive would be relatively low and, consequently, probably not worth pursuing. But, since we already have a highly progressive income tax system in America and the marginal cost of adjusting the upper tax rates to be more progressive is virtually nil, I think it makes more sense for us to opt for more progressive taxation given our particular historical circumstances.
A case for switching from progressive taxation to flat taxes can be made from the argument that “increasing taxes on wealth or the incomes of top earners depresses the capital stock and output, reducing the tax base and therefore the amount of lump-sum transfers.”(ibid.) Switching to a flat income tax from a progressive income tax could, theoretically, increase the tax base and allow for larger transfers to people at the bottom of the income distribution. This is theoretically plausible and sounds very similar to the supply-side economics position of people like Milton Friedman, who argued that tax cuts and deregulation would increase economic growth and the benefits of said growth would accrue to the poor and middle class. Historically, Friedman’s claim has not held true — the benefits of economic growth spurred by tax cuts have tended to accrue at the top of the income distribution. Given a good transfer system, if the size of the transfers were pegged to revenue in a way that would guarantee that they would increase if revenue increased, then it would be true that switching to a flat tax rate would make the poor and middle class significantly better off. Nevertheless, in reality, transfers to low income individuals are not so pegged to revenue levels. And it seems very probable that an increase in revenue from such a switch would end up funding more subsidies for the wealthy and an increase in spending on the police state and military-industrial complex — in which case, the move to the flat tax would actually make low income individuals worse off. I would argue that we ought to learn from the failure of supply-side economics and not assume that an increase in tax revenue resulting from economic growth would somehow magically increase the generosity of transfers going to low income households.
Also, it should be noted that the study in question concluded that a flat tax rate would produce “nearly optimal” results only if you had robust transfers to lower income individuals and taxed income from capital at the same rate as earned income. This means that most of the benefits that they find from this flat tax approach is predicated on imposing a much higher tax on capital gains than we currently have. “Indeed, the planner would find it optimal to tax capital income at a rate slightly higher than labor income.”(ibid.) This accounts for much of why their approach seems to be “nearly optimal” relative to progressive income tax. If you do not greatly increase the capital gains tax, the results are much less impressive.
I do, nevertheless, concede that something like Milton Friedman’s ideal tax scheme — where there is a flat income tax alongside a minimum income guarantee, enacted through a subsidy rate (negative income tax) applied to lower incomes — would be far more progressive than the existing progressive income tax system. Below is a chart illustrating how much various individuals would pay and how much they would receive under such a plan. Here we assume a taxable threshold of $3,000 per month, a subsidy rate of 50%, and a flat tax of 20% on all taxable income above the threshold. Such a plan would guarantee a minimum income of $1,500 per month to everyone.
Simply by adding transfers to the poor into the mix, the flat income tax is rendered progressive. It is my contention that whether or not such a flat tax scheme is optimal really depends on the level of inequality in the system and the goals of policy-makers. While a flat income tax scheme can be rendered progressive through more generous transfers, I do not think it would be wise to switch from our existing progressive income tax system to a flat tax.
Thus far, we have established both the necessity of taxation and the justice of progressive taxation. However, we have not discussed what ought to be taxed. For the sake of simplicity, all of our examples in this essay were simple head taxes or income taxes. Instead of taxing income, we could have taxed property, land value, value-added, consumption, carbon emissions, or any other thing. Elsewhere, in my essay The Holy Trinity of Taxes, I go into more detail on what we ought to tax and how an ideal tax system ought to be structured. I also make the case that we ought to employ several different kinds of taxes in order to make the market function optimally.
