Why are we paying taxes?

Why do we pay taxes? It is a simple question with a seemingly simple answer. Most would agree that taxes obviously need to be paid so that the government can pay for essential services in which we all share.

It was noteworthy, therefore, when elite bond investor, Jeffrey Gundlach, asked the following question on Twitter in recent days: “Why bother with any taxes at all if Chair Powell is correct that there is no limit to expanding the Fed’s balance sheet?”

Today, the Fed is purchasing US Treasury securities at approximately the same rate as them being issued by the Treasury to fund the enormous increase in federal spending associated with covid-related fiscal stimulus.

If the Fed can simply buy an infinite amount of government debt, then it must be true that the government can issue an infinite amount of debt. And if this is true, then government spending will be financed by the central bank. So why bother with any taxes at all?

Gundlach’s tweet went on: “Implicit in his declaration is that the whole tax collection system is a royal waste of resources.” This may seem like an outrageous claim, but is it?

Enter the fascinating – and increasingly relevant – world of Modern Monetary Theory (MMT). Under this economic theory, it is explicitly acknowledged that governments who issue debt in their own currency cannot default. Ever. This is because they can always print more money to repay their debts.

Instead, the constraint on borrowing and government spending becomes inflation. If governments spend too much and the economy operates above its capacity, then inflation builds and the government should reduce spending (and/or the central bank could reduce the money supply by selling assets from its balance sheet). But if no inflation builds, then spending can continue, irrespective of nominal levels of government indebtedness.

So then why do we need taxes? MMT establishes that governments can essentially print money to finance their own spending. Taxes are not required to finance this spend.

Yet proponents of MMT may not be seeking to abolish taxes tomorrow. The taxation system could be a very useful tool, even in an MMT world. Apart from the obvious ways in which governments can use taxation policy to distribute wealth in different ways across society, MMT proponents view taxes as a way to drain money from the economy. Remember, under MMT, the key constraint on government spending is inflation. And if inflation were to pick too quickly, taxes could be raised to drain money from the system. Similarly, in a disinflationary environment, taxes could be cut to leave more money in the economy.

It is a fascinating lens through which to view money, taxes and the concept of government indebtedness. Under MMT, taxes may well be important – just for very different reasons to those which underpin the conventional wisdom today.

We likely remain far away from the widespread adoption of the principles of MMT. But in the last few months, as the covid pandemic has decimated the incomes of many, the world has arguably taken its largest collective step towards such ideas.

We have seen governments around the world literally handing money to citizens to fill gaps in demand, among many other forms of stimulus. And we have seen many central banks step up to essentially finance these payments. Yet there remains no hint of inflation anywhere.

In the months and years ahead, there will be debate around how these debts are ultimately repaid. No doubt, those from the MMT community will ask the thought-provoking question: why do they need to be repaid at all?

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