Tax Revenue Is Meaningless

Let’s conduct a thought experiment. Imagine that the government is a black box whose internal workings are completely opaque to us. We know that this black box can add money to the economy through spending or remove money from the economy through taxation. But we have no idea why the government is administering fiscal policy (spending and taxing) the way it is.

This thought experiment allows us to consider the effects of fiscal policy without becoming distracted by its underlying politics. For example, what pattern of government spending is best for the economy? What pattern of taxation is best? What relationship exists, if any, between the optimal taxation pattern and the optimal spending pattern?

In an ideal world, we would want this black-box government to behave in the best interest of the people. The economy only has limited resources (e.g. materials and labor) available to produce things that people want and need. The optimal fiscal policy is the one that best allows the economy to sustainably use its resources to support the common good.

The government directly purchases some resources and the private economy handles the remaining resource allocation. To the extent that any available resources would otherwise remain unused, the government can give people spending money to access those resources.

The role of government spending is generally to activate resources and the role of taxation is generally to conserve resources. If meat production takes up too much land, for example, then you could free up some land by taxing the sale of meat.

For fiscal policy to have any effect on the economy, taxation must not match government spending. If the government’s taxation pattern perfectly matched their spending pattern, the two would simply cancel each other out. In particular, there’s no reason why the economy’s optimal fiscal policy would somehow align the total amount of government spending with the total amount of taxation.

Well, that was a cute little thought experiment I just walked you through. Alas, the real-world government is not a black box. The real-world government faces real-world budget constraints. But what would happen if the US government woke up tomorrow and decided to do away with the fiscal budget as we know it?

In 1945, that’s exactly what New York Fed chairman Beardsley Ruml advocated. Toward the end of World War II, he wrote a paper entitled Taxes for Revenue Are Obsolete.

The necessity for a government to tax in order to maintain both its independence and its solvency is true for state and local governments, but it is not true for a national government. Two changes of the greatest consequence have occurred in the last twenty-five years which have substantially altered the position of the national state with respect to the financing of its current requirements.

The first of these changes is the gaining of vast new experience in the management of central banks.

The second change is the elimination, for domestic purposes, of the convertibility of the currency into gold. — Beardsley Ruml | Taxes for Revenue Are Obsolete

Ruml was right in 1945 and he’s still right today. But I would take this argument even further than Ruml did. If we want our state and local governments to behave as optimal fiscal black boxes too, their spending can’t be funded by taxes either. Instead, we should expect the federal government to fund the states.

That’s all well and good, but what about inflation? It turns out that inflation is less about the amount of money in the economy and more about the amount that people are spending compared to the amount of stuff being produced for them. Inflation occurs when consumer spending outstrips production. Recall that our ideal black-box government will only activate available productive capacity and go no further. If we were to let this government cause inflation then its fiscal policy would no longer be ideal.

By all odds, the most important single purpose to be served by the imposition of federal taxes is the maintenance of a dollar which has a stable purchasing power. Sometimes this purpose is stated as “the avoidance of inflation”; and without the use of federal taxation all other means of stabilization, such as monetary policy and price controls and subsidies, are unavailing. — Beardsley Ruml | Taxes for Revenue Are Obsolete

Here I disagree with Ruml. Monetary policy should usually work just fine even in the absence of taxation. Whenever fiscal policy puts pressure on the purchasing power of the dollar, monetary policy steps in to compensate. Monetary policy makes it harder and easier for people (and businesses) to borrow thereby influencing how much money everyone spends.

It is true that when tax revenues are insufficient to cover government spending, the government has to borrow. Does that mean we run into problems when the national debt or deficit climb too high? The short answer is no. We can safely ignore the national debt and the deficit. The government can borrow from itself, so the mechanics are internal to the black box.

For a more in-depth discussion of the national debt, you can watch our basic income discussion group from September 19th.

TL;DW: Independent of the government’s fiscal budget, the Fed can precisely control the amount of government debt outstanding in the market. This is part of how monetary policy keeps prices stable. Monetary policy is interesting in its own right, but that’s a whole other blog post.

In conclusion, it’s not that tax revenue is meaningless per se. It’s that tax revenue should be meaningless. The fact that it has meaning is a clear indication that the government is functioning incorrectly. They are making a mistake by assigning meaning to tax revenue. We would be wise to avoid the same mistake as we attempt to imagine better fiscal policy.