Do taxes give a currency its value, and if not, what do we need taxes for?

I’m at risk of becoming a John Kay fan-blog, but he’s discovered MMT this week, and tries to debunk the MMT view that it is government taxes that give currencies their value:

A theory called chartalism, which sounds cranky, or modern monetary theory, which sounds better, argues that money derives its value from the willingness of governments to make payments and accept taxes in it. But this is easily refuted. Suppose the Scottish government would only accept payment in highland cows. There would be an active trade in highland cows to meet tax payments, but people would continue to take their banknotes ā€“ English pounds, euros, or US dollars, as Tesco preferred ā€“ not cattle to the shops. The ingenious folk at RBS would quickly create tradeable highland cattle certificates.

While this is operationally undeniably true — highland cows being an inconvenient enough unit for trading, people wouldn’t take them to the shop however valuable they become due to their value for tax paying purposes — does it invalidate MMT? By collecting taxes in the currency it issues, the government does have some leverage to influence its value, but it may indeed not be the essential thing that makes people use currencies. A failed government might find its currency abandoned for day to day trading, whatever the law says.

It would be interesting to see how much of the Greek economy keeps on using the euro as a unit of trade (pricing, savings) if the Greek government leaves the Eurozone. In an economy with a strong tourism sector, they have a ready made influx of banknotes, and unless they become North Korea, it should remain practical for Greeks to operate euro bank accounts in non-Greek banks, and in the SEPA area they could easily pay each other by doing transfer between those accounts. Private operators could even set up a network of euro-dispensing ATMs. So you could well end up with a two speed society where only public sector employees use the new currency and try to exchange it as soon as they get paid for euros that are used by the private sector, top down from the tourism sector, and less at risk of quickly losing their value. It’s quite possible that the Greek government has already lost enough credibility that it couldn’t get (all) Greeks to use a new currency it issues, even if it wished to.

If taxes have only a marginal role in making a currency valuable, and things like trust in a stable issuer and conventions are a more overwhelming factor in their continued used, maybe we can get rid of taxes completely. A good thought experiment is to try and think what happens to a system where state spending is still done by government with the currency it issues but tax is not used as the inflation regulation mechanism, as per Warren Mosler‘s famed:

Taxes function to regulate aggregate demand, and not to raise revenue per se.

To reduce the system to its simplest form, what happens if we have a system:

  • All government expenditure is funded by currency issuance
  • The treasury is not allowed to save or borrow (no bonds, no savings, funds are released by the central bank only to pay public sector employees and suppliers)
  • The central banks is still in charge of maintaining an inflation target, through the interest rate it charges on reserve
  • It may not be essential, but let’s also assume the replacement of coins and notes with electronic money, which enables the central bank to charge negative rates on reserves (if cash exists only electronically, it cannot be kept under the mattress to escape the negative rate)

So we’ve still got an inflation control mechanism: the central bank can compensate any government spending profligacy by charging punitive rates on bank reserves which should suck up excess liquidity as soon as it’s spent by the government.

The detailed implications of such a system are beyond me, but I suspect this could well work out. Perhaps the hardest thing to get right would be to have people keep trust in the currency after the abolition of taxes, even if could be formally proven it’d work on paper. Trust depends on more than mere facts, unfortunately.

If taxes are not even useful to give value to a currency, what are they useful for? The obvious thing that comes to mind is redistribution, but this also seems immediately invalid, because anything that can be done by taxing some and giving to some others, can also be done by giving more to the others. The government just needs to make more cash or services awards to the needy, which will be, in negative, at the expense of the wealthy. Given how tricky it is to collect tax efficiently from the wealthy, this seems outright desirable. So, as such, the idea that you could operate with no taxes is independent of the desired size of government — it’s an operational question that leaves the size of government question free.

Sounds too good to be true? First, it’s not that “good” as such: it’s an operational change that need not change anyone’s net position, beyond reducing administrative burden some, or actually merely moving it around to the enlarged positive awards system. Second, if untrue, it would be enlightening to understand the mechanism through which it would not work.

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