Imagine for a moment a society without compulsion. People are working for themselves and each other. They might share, barter or agree to use a private money or monies in exchange. If everybody could somehow agree to share land and other natural resources, respect the wishes of all, contribute voluntarily to the production of infrastructure and provision of social services, agree to the modes of production in which they personally need to engage (whether wage labor, cooperatives or communes) and address all other individual and collective needs on a voluntary basis, there would be no need for government and no need for state money. A role for government arises when members of the community cannot find amicable solutions to all conflicts without some mechanism for orchestrating their collective will. Fiat money is a highly effective tool for this purpose.

A minimalist conception of government might confine it to the defining and upholding of property rights. More expansive conceptions also envisage a role for government in facilitating a degree of cooperative social and economic activity that might not otherwise occur. There is a range of possibilities, with big government at one end and small government at the other. Ultimately, the size of government has a political determination.

To the extent a transfer of resources from the private to public sector is deemed desirable, there will be a resort to compulsion of one form or another to ensure sufficient collective behavior. This will be so until we can all learn to cooperate voluntarily, without compulsion.

In a state money system, the compulsion necessary to transfer resources to the public sector is introduced through the tax obligation. Taxation compels a degree of cooperative behavior by withdrawing private spending power. This frees up some resources for use in the public sector. Without this compulsory withdrawal of private spending power, wealthy individuals and large corporations could impede the intended cooperative activity through their market clout.

By requiring that taxes be paid in the state money, the government also creates a demand for that money, ensuring its viability. The fact that individuals and businesses need to obtain fiat money in order to pay taxes ensures a willingness to sell goods and services to the government. Successful tax enforcement is a sufficient (though not necessary) condition for a money’s viability.

Even though there is compulsion in the mechanism for transferring goods and services to the public sector, there need not be any compulsion in the determination of government policy objectives. Ideally, the process will be open and democratic. (This aspect of fiat money is considered in greater depth in Taxation, Money, Freedom and Economy.) In terms of the transfer of resources to the public sector, the following can be discerned:

— Since fiat money originates with the government, and since taxes are payable only in the government’s own money, individuals and businesses cannot pay any tax until the government has spent or lent some money into existence. Government expenditure and lending are logically prior to tax payments, and in a sense “finance” tax payments. (This point is discussed further in Fiat Money and its Social Significance.) This does not mean that money is the source of real wealth, or that the government as monopoly issuer of fiat money creates all real wealth. It simply means that the government is able to command some of society’s real resources through its position as monopoly issuer of the very thing that is required to meet the tax obligation.

— The government cannot receive more in tax payments than it has previously created through spending or lending. Public spending and lending create the government’s fiat money; tax payments destroy it. It is possible to run fiscal surpluses for a time. This is achieved by non-government running down its accumulated financial wealth in order to meet tax payments in excess of the government’s expenditure over the period. But, unless the country is running an ongoing current account surplus that is sizable relative to the total size of its economy, continuous fiscal surpluses are unsustainable because they eventually push some households and businesses too far into debt, precipitating a financial crisis. (The posts Budget Deficits and Net Private Saving and Government Spending and Financially Sustainable Growth elaborate on this point.)

— The government adds to the level of demand and income whenever it spends. If it employs people who would otherwise be unemployed to do work, the expenditure leads to the production of additional real output. If the government places an order for goods produced by the private sector, it provides an impetus for production so long as the private firm has spare capacity with which to respond. Whenever there is excess capacity and idle resources, including unemployed labor, government expenditure can be used to activate production, adding to real output and employment.

— However, individuals and businesses will only be willing to transact with the government to the extent that the government’s money has value. If a state money drops sharply in value, a unit of it (e.g. a dollar) will not command as many goods and services as it did previously, and be less attractive as a form of wealth. Moreover, non-government will be able to meet a given tax obligation with a smaller transfer of resources to the public sector, and so have less need of such transactions.

— According to Modern Monetary Theory (MMT), the value of fiat money depends on what must be done to obtain it. For example, if government sets the minimum wage to $10 per hour, it will take 6 minutes of minimum-wage labor or its equivalent to obtain one unit of the currency. (See Demand for the Currency & Value of the Currency.)

— Price stability requires, in part, that government spends at levels appropriate given the spending and saving behavior of non-government. All spending, whether private or public, carries inflation risk if the economy is operating near full employment. If government net spends more than non-government desires to net save out of full-employment income, there will be demand-pull inflation.

— The government can control the direct effects of its spending on prices by exogenously setting the terms of its transactions. For example, the government can exogenously set wage rates applicable to employment in the public sector. This will determine the prices of one hour of various kinds of labor in the public sector which in turn will influence wages and salaries in the private sector. In particular, wage rates and salary levels in the private sector will need to be competitive with those in the public sector. At a minimum, the government need only set one wage rate. More generally, as the monopoly issuer of its own money, the government is in a strong position to specify the prices it pays for goods and services supplied by the domestic private and external sectors.

— Even so, the ability of the government to buy at stable prices depends on the availability of goods and services. If demand is already sufficient to sustain full-employment output, there is no further room for the government to increase its spending in a non-inflationary manner. If the community still demands further transfers of goods and services to the public domain, taxes would have to be increased to reduce private demand. Alternatively, if society prefers a larger role for the private sector, cutbacks in the government’s expenditure would be required.

— The extent to which society wishes resources to be transferred to the public sector determines the appropriate size of the tax obligation. If society wants most activity to take place in the private sector, the necessary tax obligation is small, since the government will have less need to reduce private spending power. If a big role for government is desired, a bigger tax obligation is required. Otherwise the desired transfer of goods and services to the public domain cannot be carried out in a non-inflationary manner.

 
Further reading

Here are two scholarly analyses of the issues discussed in this post. The first is by Randall Wray, the second by Pavlina Tcherneva.

Money and Taxes: the Chartalist Approach
Chartalism and the tax-driven approach to money