In reaction to MMT statements that government spending must occur before taxes can be paid, it is sometimes noted that a household could pay taxes by borrowing from a bank that subsequently obtains reserves from the central bank. Whether this is true from inception of a modern money system will depend on the terms set down by the central bank in advancing reserves to banks. But supposing the terms are permissive, would it change anything of macroeconomic significance? Let’s take a brief look.
Government money. Payments to government are finally settled only in ‘government money’, meaning reserves or currency, almost always reserves. In a modern money system, the original source of reserves and currency is government.
Bank money. A bank loan to a taxpayer creates a deposit that is the bank’s promise to deliver currency on demand or at a particular time and to have a sufficient balance in its account with the central bank (sufficient reserves) to enable the final settlement of payments drawn from the account.
Borrowing to pay tax
Consider the scenario of a taxpayer borrowing from a bank to meet the tax obligation. Two cases are relevant, differentiated by the terms central banks might attach when advancing reserves to banks.
Case 1 – government bonds required as collateral. From inception of a modern money system, a bank that lends to a taxpayer will subsequently need to obtain reserves to ensure it can fulfill its promise to the account holder. It can obtain reserves from the central bank. Under current practices, the central bank typically requires collateral in the form of government bonds when advancing reserves. And, under present arrangements, the government bonds needed as collateral are the result of past government spending. In this case, the taxpayer cannot take out a loan to pay taxes before government spending has occurred, because banks will not possess the bonds needed as collateral when obtaining reserves from the central bank.
Case 1 conclusion: if the central bank requires government bonds as collateral when advancing reserves to banks, government spending does indeed need to occur before taxes can be paid.
Case 2 – government bonds not required as collateral. But let’s say the central bank decides, from inception of the modern money system, to supply reserves to banks without requiring government bonds as collateral. The taxpayer will then be off the hook tax-wise, having met the tax obligation by borrowing from a bank, though will be on the hook to the bank. A net liability of non-government to government, initially created by the tax, will still remain. But the liability will now be held by another member of non-government (the bank) and will be in a different form. It will now be a loan liability rather than a tax liability. The bank will be liable to government for the amount of the loan (equal to the tax). Until government spends, the non-government’s financial liability will remain in some form.
Case 2 conclusion: if the central bank does not require government bonds as collateral when advancing reserves to banks, taxes can be paid before the government spends, but only by non-government converting a tax liability into another liability. The liabilities of non-government to government will remain in some form until government spends.
To state the MMT result in more general terms (in order to allow for the theoretical possibility of the individual taxpayer meeting the tax obligation by borrowing from a bank permitted to obtain reserves from the central bank without supplying government bonds as collateral), we can say:
A currency-issuing government must spend before net financial liabilities of non-government to government can be met.
This is a macro way of looking at the situation.
Nothing of substance changes
Nothing of substance changes under the more general statement. Key MMT conclusions continue to hold, including that: (1) a currency-issuing government faces no revenue constraint in the currency of issue; and (2) taxes imposed (and effectively enforced) by government are sufficient to drive acceptance of the currency.
1. No revenue constraint. Since the net financial obligations government imposes on non-government cannot be eliminated until government spends, the funds non-government needs to extinguish its net financial liabilities to government come only from government spending. Accordingly, the financial liabilities government imposes on non-government do not (and cannot) provide initial finance for government spending. Government spending is self-financing – government creates ‘government money’ in the act of spending – and government spending creates the funds needed by non-government to eliminate its net financial liabilities to government.
2. Taxes drive money. Whether a taxpayer takes out a bank loan to pay a tax or pays the tax without borrowing, the final settlement of the tax payment requires reserves. Taxes, like any financial obligation of non-government to government, can only be finally settled in reserves. The imposition and effective enforcement of taxes is therefore sufficient to ensure acceptance of the currency.