Why Do We Pay Taxes? | Money for The Rest of Us

The seemingly obvious answer is we pay taxes to help fund the government so it can pay for government services. That is correct when it comes to state and local governments as well as for the federal governments of countries that don’t issue their own currency. For countries like the U.S., Japan and the U.K. which issue their own currency the question of why we pay taxes is a little more complicated.

Two grey pencils on an orange backdrop with words saying "Why Taxes" for Investing Podcast Money for the Rest of Us — Photo by Joanna Kosinska

Government Spending Is Digital

When the federal government spends, it deposits money into a private-sector checking account by coordinating the payment with the Federal Reserve, the U.S. central bank. The private sector checking account balances are adjusted upward to reflect the new deposit while the U.S. Treasury’s account balance at the Federal Reserve is reduced.

When we pay taxes the opposite happens. The checks we write to pay taxes reduce our checking account balances. The federal government’s balance at the Federal Reserve increases.

These payments, like most payments in the financial system, are digital. No paper bills or coins are exchanged. Bank account balances are adjusted upward and downward digitally.

The Federal Reserve Has Unlimited Money

The Federal Reserve has shown through its asset purchase programs, also known as quantitative easing, that it can create as much money as it wants to purchase U.S. Treasury bonds. The Federal Reserve purchased several trillion dollars of U.S. Treasury bonds from its member banks. The banks transferred the U.S. Treasury bonds to the Fed while at the same time, the Federal Reserve paid for the bonds by increasing the banks’ reserve balances held at the central bank. In other words, the Federal Reserve digitally changed the reserve account balances without having to find the money. The Fed created the money out of thin air.

In theory, the U.S. Treasury could just sell bonds directly to the Federal Reserve to replenish the federal government’s bank account at the central bank. That would allow the U.S. government to spend money without having to tax. Or the Federal Reserve could just fund the U.S. Treasury’s checking account directly and not worry about buying government bonds.

The point is there is an infinite supply of digital money. That doesn’t mean there aren’t constraints. If too much money is created by the banking system that can lead to inflation, which is a measure of rising prices. While there is an infinite supply of money, the private sector can only produce a finite amount of goods and services. When the private sector’s capacity to produce gets constrained, businesses raise their prices.

For Now, The Private Sector Funds the Federal Government

In practice, the U.S. government continues to tax and issue bonds to the public. It does not rely on the Federal Reserve to fund its spending. Instead, the funding comes from the private sector. That’s probably a good thing because it ensures some spending discipline and reduces the risk of inflation. It also allows citizens to feel like they are contributing to the nation’s fiscal welfare.

Episode 186: Why We Pay Taxes

We explore why we pay taxes in more detail in Episode 186.

Topics covered in the episode include:

Why we pay taxes in order to prevent inflation, to feel like we are contributing to the democratic process, to provide a sense of fairness and for political aims.
How the 2017 U.S. tax reform act could impact home prices, charities, and higher-tax states.
How large is the tax cut and who it will benefit.
What will the impact of the tax cut be on the economy and deficit.
What is the Pay As You Go Act.

Episode Chronology

[0:51] Residents of Denmark are able to prepare and file their taxes in 10 minutes
[1:40] Are you going to get a tax cut from the recent legislation that was passed?
[4:01] Foundational principles about why we pay taxes in the first place
[8:44] Assessing the new tax laws after the fact: They were trying to simplify. But does it?
[17:32] What impact is the new tax legislation going to have on the economy?
[21:10] Corporate income taxes have changed from 35% to 21%, and no more taxes on overseas earnings
[27:39] Technicalities that still need to be worked out regarding the recent tax reform