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Why Taxes Don't Matter Much Anymore

Mises Daily: Thursday, August 28, 2008 by

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[This article originally ran on InsideCatholic.com.]

Barack Obama's tax advisers recently posted a piece in the Wall Street Journal about their candidate's tax plans. Their article was designed to triangulate, painting their candidate as a tax cutter and the Republican opposition as a secret tax raiser. It was well written and well argued — not that you can really trust anything you read about what candidates will or will not do once in office.

In any case, I was discussing the piece with a person whose politics are certainly left of center. She said to me something along the following lines:

I'm really not sure I understand all this tax talk. The government taxes us to get money to do what it wants to do. But it seems like what they do — whether going to war or funding new projects — is never discussed in terms of money they have or don't have. I mean, Bush cut taxes, right? And the reduced revenue should have restrained him. But he spends on whatever he wants. The tax cuts didn't seem to reduce his power at all. Why is this?

It's a good question. Why is it that talk of tax policy doesn't seem to have a relationship to policy generally? Whether it's a bailout of subprime mortgage holders, large investment banks, or going to war, whether or not the resources exist to do these wonders rarely enters into the equation. Why is it that tax cuts don't curb the government? And why do politicians not feel the need to tax us more when they spend more?

You might at first say that the answer is simple: they just go into debt by running an annual deficit. And the debt today stands at some figure that has no real meaning, because it is too high for us to even contemplate. What does it really mean that the debt is $5 trillion or $10 trillion? It might as well be an infinite amount for all we know. At least that's how the political class acts.

Reference to the debt only begs the question. You and I have to pay our debts. We cannot run up an infinite amount of it without getting into trouble and losing our creditworthiness. In the private sector, debt instruments are valued according to the prospect that the debts will be paid. The likelihood that it will be covered is reflected in the default premium. But the debt of the US government doesn't work that way. The bonds of the US Treasury are the most secure investment there is. It is valued as if it will be paid no matter what.

If not through taxes, and if not through infinite debt, how is it that the US government gets the money it wants regardless of other constraints?

The answer here comes down to the monetary regime, a topic that causes eyes to glaze over but which is central to why the government seems completely out of control. It is not difficult to understand if we think of how a criminal with a counterfeiting machine might behave. Would we see fiscal restraint? Of course not. If a person could create all the money he needs or wants with a printing press, we would expect unlimited profligacy. This is precisely what the Federal Reserve does. It not only acts as the guarantor of the liquidity of the banking system but also functions as the guarantor of the entire government financial system.

Given this, it is hardly surprising that there seems to be a strange disconnect between tax policy and spending policy. The politician isn't concerned about it any more than the counterfeiter worries about the bills coming and going. They know that the money is going to be there if they need it. This is not only bad policy in general, but it introduces an occasion of sin for the political class. It is too much to ask of anyone to be financially disciplined if he has the capacity to create out of thin air all the money he wants.

What is the downside of this type of regime? The bills are ultimately paid by you and me in the form of price increases for goods and services. To make the connection here, imagine the value of money is like lemonade: the more water you add to the fixed amount of lemon juice, the weaker it becomes. We tend to think of inflation as the price of things going up, but in fact inflation is nothing more than a decline of the purchasing power of money itself.

There are other consequences, too. The way the Fed creates money involves manipulation of the interest rate. But the market rate of interest serves a purpose. When it goes up, it rewards saving and discourages borrowing. When it goes down, consumption and investment spending receive a subsidy. When the Fed feeds the popular desire for low interest rates, it is injecting newly created money into the system in a way that creates investment bubbles. These bubbles can be a symptom of a larger problem, namely, the business cycle itself.

Those of a historical bent will note that today's monetary system has features that are essentially unprecedented in American history. The dollar is not backed by anything other than the promise of the state. There is no gold or silver or anything else that the paper represents. Nor is the paper in your wallet convertible into any other monetary unit but more paper.

"It is not difficult to understand if we think of how a criminal with a counterfeiting machine might behave."

The system we have now is about 35 years old, and it began after Richard Nixon declined to pay foreign dollar holders in gold. That was the final end of the gold standard. With that action, he inaugurated the new age of paper money — and ever since, the rate of inflation, the wild swings of business activity, and the growth of government have been completely out of control. It was a disastrous decision, but the unsurprising culmination of a long process of monetary destruction that began just before World War I when the Federal Reserve was created.

How might money work in a perfect world? We have to look back at earlier times and see that central banks are not necessary. Banking, like any business, can be a market institution and manage itself just like the shoe or coffee industry. Money need not be paper, which can be infinitely reproduced. It can be gold and silver, which have a fixed supply. When the government wants to spend money, it has no choice but to persuade people to fork over the money. The citizenry, under these conditions, tends to pay closer attention to what its masters are planning.

With sound money and no central bank, the debate over our country's future would take on new meaning. Politicians would feel the constraint — the same as all individuals. It would be a more peaceful world, surely, with far less political meddling at home and abroad. And we might actually start taking public affairs seriously again.