Why Are There Taxes?

In a recent post on the concept of a “stock of savings”, I argued:

In a proper money economy investment does not depend on anyone’s conscious decision to save. All it requires is the purchasing power to bid away resources into investment use. This purchasing power can be amassed by abstaining from consumption, as in the realist scenario. However, the more practical scenario is to solicit a loan from the bank. In a money economy, the bank creates the money ex nihilo, marking up its assets and its liabilities in a stroke. This is a fundamentally different operation than the intermediation of accumulated savings in a Ricardian-realist economy. The investor is able to bid away resources from other uses without any deliberate abstention on the part of would-be consumers. There is no “stuff” saved up for him to borrow, and the money he borrows does not in any sense represent saved up stuff.

If this is correct, taxation should be exactly analogous. Instead of banks with constrained money-creation power through making loans, we have a central bank with unconstrained money-creation power. And just as investment doesn’t need to be financed by “savings” when there are banks, government spending doesn’t need to be financed by taxation when there’s a central bank.

It’s certainly not obvious that monetization is more distortionary than a giant and unwieldy tax code. In fact, taxation is an enormously difficult and expensive way to finance spending compared to monetization. So why do we see taxation at all? Why is monetization usually considered a last resort?

1. The most obvious reason is macroeconomic stability. Bidding away resources using new spending bids up their prices, which ends up reverberating throughout the economy as inflation. Taxation diminishes private spending in (not necessarily strict) proportion as it increases government spending, and so avoids inflation.

2. But, pace some chartalists, it seems rather implausible to think of governments as consciously and continuously managing the flow of spending through fiscal policy. If it’s not about revenue, they argue, it’s about aggregate demand. But governments knew about debasement and monetization and its effects long before the concept of aggregate demand or the notion of its management existed. More likely, a commitment to taxation rather than monetization is about credibly limiting government spending, Kydland & Prescott style. As Brennan and Buchanan argue, forcing the government to raise revenue in an inefficient manner is an incentive-compatible way to limit government consumption. Similarly, governments may find themselves unable to commit to avoiding high inflation unless they commit to financing spending through a relatively costly method. And without the ability to commit to low inflation, demand for their currency is impaired, making it more difficult to monetize at all. No doubt advances in credibility and taxation technology were necessary for the preponderance of floating fiat currencies in the developed world. In a different time or place, when monetization was much easier than taxation – and thus more tempting – devices like the gold standard or fixed exchange rates were necessary to keep government consumption within reasonable bounds.

3. Most importantly, I think, the non-neutrality of taxation is actually what makes it desirable to governments. Monetization, to the extent that it disrupts relative prices, alters fortunes in a more or less idiosyncratic and unpredictable way. Taxation, on the other hand, admits of much finer control over the distribution of the burden of government spending. And in this way, governments are able to cement their legitimacy and build political support.

This is a significantly different model of government finance than a revenue-maximizing Leviathan. Even if monetization entailed no inflation, governments would still prefer taxation as a coalition-building tool. North, Wallis, and Weingast (2009, ch. 3) argue of 16th Century England:

the Court [of Wards and Liveries] was never run in a way that maximized revenue from wards and liveries. The king received only a quarter of the price paid for wardships. Lord Burghley was master of the court from 1561 until his death in 1591, and he actually administered the court to benefit members of the king’s coalition rather than to maximize revenues. . . . When Burghley died, his son Cecil took over. Cecil began administering the court as an instrument for raising revenues, squeezing out the intermediaries. Although the annual revenues of the court rose by almost 50 percent in the 1590s, by the early 1600s the court had lost its political support in parliament and was headed for extinction. Used as an instrument of a natural state coalition, the court was politically viable. Used simply as a mechanism for extracting revenue, it had no place in seventeenth-century England, and was abolished. Thomas (1977) finds an exact parallel to Burghley’s use of the Court of Wards and Liveries in the policy of leasing crown lands to favored servants on extremely favorable “reversionary” leases. Land was always used this way by the crown.

If you’re maximizing revenue without respect to your base of support, you may as well not tax at all and just monetize. By the same token, the more radical flat tax proposals, by constraining the government’s ability to use discriminatory taxation to build coalitions, makes taxation relatively less attractive than monetization. Again, you may as well monetize.

North, Wallis, and Weingast make this discretionary coalition-building an essential part of premodern “natural states”, as opposed to modern “open access orders”. Maybe the difference is not so much in the necessity of buying off a sufficiently large coalition, but rather that in the open access order it has become regularized and sublimated into a taxation apparatus. After all, the historical advent of open access orders did correspond to a dramatic increase in the effectiveness and regularization of taxation.

Just as natural states mature when elites demand security from and constraints upon the vagaries of discretionary coalition building, maybe something like a flat tax is a necessary step in the evolution of some form of political organization even more complex and regularized than the open access order. Or maybe, by breaking the incentive-compatibility of not monetizing spending, it leads to rampant monetization, hyperinflation, and the dissolution of the money economy. But both, of course, are far too speculative to count much for or against the merits of different taxation schemes.