Zero Tax II

Gavin Putland, a research officer for Prosper Australia, has picked up on my Zero Tax proposal and published a critique of it. It would be good for you to read his blog article before progressing any further, as much of what I write here will be in answer to his critique.

I need to point out before starting that I had emailed Putland with my proposal and asked him for his response. The reason is that Putland himself has created a theoretical economic system that does away with tax as well. I won't be critiquing his approach since I need more time to understand it, but I would certainly encourage anyone reading this to check out Putland's theory for themselves.

One of the common criticisms of my original proposal is that, in order to keep government funds being created by seigniorage without inflation, the Reserve requirement would have to keep increasing until it reached 100%. This was pointed out by "Leonard" at Megan McArdle's blog. Yet if you read McArdle's blog, you'll see that "Leonard" also advocated the complete abolishment of the fractional banking system, which sort of skews his understanding of how fractional banking works and how my system fits into it. Then again, I'm the one with this crazy idea to abolish all taxes so I suppose we're even in that regard!

The thing about fractional reserve banking is that the amount of money it can produce is infinite. In order to understand it, I suggest readers familiarise themselves with this practical example available at Wikipedia. If the reserve requirement of an economy is set at zero (as it is in Australia) then there is no limit to how much money can actually be created through the money multiplier. Increasing this reserve requirement will result in substantial amounts of money NOT being created as it is multiplied.

This is important to understand. I think Putland (and others) have it in their mind that there is a direct relationship between the money supply and the rate of inflation. In other words, if the money supply is increasing, then so is inflation. If the money supply is decreasing, then deflation results. This is not so.

Inflation and deflation are both monetary phenomena but they are not determined by whether or not the money supply increases or decreases. Rather, they depend upon market forces - namely the market's valuation of money itself. In other words, it is quite possible to have both deflation and an increase in the money supply, just as it is possible to have both inflation and a decrease in the money supply.

The reason is that supply is always balanced by demand. If the demand for money is greater than its supply, then money will become more valuable - and deflation will result. If the demand for money is less than its supply, then money will become less valuable - and inflation will result.

In my zero tax system, I do away with all forms of taxation and replace them with that most horrendous of government sins - the printing of money. Yet rather than create an inflationary spiral, the increase of the reserve rate will remove money from the money supply, thus balancing it out and removing any hyperinflationary effect. Putland and "Leonard" would argue that the increasing reserve requirement would eventually reach untenable levels (100%), this making this system, well, stupid.

My argument is, obviously, that this will not happen. The reserve requirement will be quite high but it is highly unlikely to reach even beyond 50%. The reason for this is obvious - money, by being infinitely fungible, can be easily created and destroyed through monetary policy, of which the reserve requirement has been a part of over time.

How high can interest rates go? Here in Australia at present, the Reserve Bank has a cash target rate of 6.75%. What would happen if the RBA increased rates to, say 10%. What about 20%. Why not 100%?

Of course the RBA isn't going to raise rates that high just for the sake of experimentation. Nevertheless we can make reasonable extrapolations as to what might happen. If the RBA raised rates to 20% all of a sudden, the result would be a severe economic downturn accompanied by a major bout of deflation. The reason for this is simple, by raising rates the RBA has acted to reduce the money supply, and, with demand exceeding supply, money becomes very valuable indeed, which means that the price of goods and services decline in relation to it, which is deflation.

The fact is that the RBA's use of monetary policy can be deflationary if it wants to be. Any central bank, from the Bank of England to the European Central Bank to the United States Federal Reserve, has this power at its fingertips if it wishes to.

It seems ridiculous, therefore, to argue that central banks can't create a deflationary environment. That is, in essence, what Putland and "Leonard" are arguing. The reason I am pointing this out is that, in my zero tax proposal, with the money from seigniorage (money printing) entering the money supply and creating an inflationary environment, it seems illogical to assume that central banks could NOT somehow create a deflationary action that balances it out.

I think that the reason for Putland's critique is that he probably does not understand how fractional reserve banking works. Understanding the money multiplier effect in the context of an economy in which money is bought and sold is essential. My eventual understanding of this effect is the reason why I was able to pull this proposal from the shelf and publish it - previous to that I had no faith that it would work since I had a less than rudimentary understanding of the fractional system.

Moreover, I don't think Putland understands how to describe the problems of my system correctly. For example, he states:

If the tax burden were indeed simply replaced by higher interest, this would be bad enough, because it would encourage hoarding of money and deter productive investment.

Putland avoids the use of the word "deflation" here. Why? What he has described - the hoarding of money - is a classic result of deflation. So, in other words, he is arguing that my proposal would be deflationary. Yet he doesn't use the word.

Notice also this paragraph:

Even in the absence of taxes, such a huge interest margin would be ruinous to depositors and borrowers. Both parties would need to "cut out the middleman", but this would be illegal because the "middleman" also happens to be the tax collector. So the only source of credit would be the underground economy, and life would be "solitary, poore, nasty, brutish, and short."

What Putland describes here is a system in which banks have such control over our deposits that it would be "ruinous" to place our money into such institutions. But what is he inferring here? Is he saying that, by increasing the reserve requirement so high that people would be unable to access their money if they so desire? Since the reserve requirement is a hidden "tax", would that mean that people would be forbidden to take money out of the bank?

If this is Putland's thinking, then he certainly doesn't understand fractional reserve banking. The fact is that, even in today's environment, if everybody went to the bank to withdraw their money the result would be complete disaster. It is called a bank run.

Yet why would people under my system be worse off? I have said nothing about the rights of people to withdraw their money from the bank, nor did I say anything about preventing this from occurring. The reserve requirement only applies to money that the bank has in its deposits. If a bank has $10bn in deposits, and if the reserve requirement is 10%, then $1bn has to be held in reserve. If the bank loses a lot of customers and deposits fall to $9bn, then only $900 million should be held in reserve.

If Putland has a theoretical problem - what would happen if people wanted to remove their money from banks whose reserve requirement exists as a deflationary measure to balance out government seigniorage - then he should be worried about our current system. Yet in our system people have money in bank deposits and are happy to have them. The fact that a high reserve requirement exists or not is not the issue.

Moreover, Putland fails to understand that, with the natural increase in market interest rates that would result in my proposal, households and businesses would actually see bank deposits and other savings accounts to be quite attractive. As interest rates go up, the entire economic system rewards those who save, which means that many people would increase their rate of savings (insofar as inflation is controlled; higher inflation would lead to less savings). All in all, households and businesses would not view banks and their deposits any differently under my system as they do now.

Next, Putland quotes "Jeff", a commenter at the Angry Bear web page which discussed my proposal:

If you make the banks sit on more and more cash each month that they are not allowed to use it is the same thing as a tax.

Basically you have created a source of money in your money printing to fund the government, and you have created a sink for money with the reserve requirement. It is the same as if that money the banks are not allowed to touch had gone to the government, and the government had not printed money. So if such a system could ever balance you would have simply replaced the current tax system with an effective tax on bank deposits.

There is much in Jeff's statement that is true. My zero-tax economic system is not a free lunch. Government spending has to be paid somehow. I am not proposing a magic tax-free utopia. What I have done is, according to Putland, is a "tax/interest trade-off". All I have done is replace taxes with higher interest rates. Yes, that is what I have done. Guilty as charged. Yet I would still argue that my proposal is fairer because it affects the entire market (and thus affects the rich more than the poor, which means that its effect is essentially progressive rather than regressive) and is more efficient because it does away with an entire section of the economy dedicated to tax collection and avoidance (government tax departments, tax accountants, tax laws, tax lawyers, etc). Moreover, the resulting increase in money supply and reserve requirement will need far less resources to achieve than the current tax system.

It needs to be pointed out that in the system I am proposing, the entire government is funded by seigniorage (money printing). There are no other forms of revenue. The reserve requirement cannot be considered a tax because it is not spent. Instead, it is held at the central bank. But then, of course, there is the problem of whether or not such reserves can be sustained - what would happen if people wanted to take out their deposits and thus remove these reserves? Again, the problem is simply identical to a bank run and the same question could be asked of our current economy today. What I am pointing out is that the behaviour of depositors and lenders is not going to suddenly take a peculiar turn if this system is enacted.

Another problem with Putland's critique is that he has not taken into account the effects of zero tax upon the economy. He says, for example:

the burden of the tax on bank deposits would be passed on to customers in the interest margin — that is, the margin by which the interest paid by borrowers exceeds that paid to depositors.

Of course my proposal has negative effects. High market interest rates would be a natural result. Yet he is unable to realise that, even with such negative effects, there are positive ones. With no taxes to pay, households have more money to spend. A person may owe more money, but they also have more money. Certainly interest margins, which occur naturally in banks, will be affected. Yet Putland does not take note of the changed financial circumstances of households and businesses - namely, that they have more money as a result of zero income tax. To be sure, this increase in income sounds inflationary, but the increase in interest rates will ensure that the majority of this extra money will go into savings rather than spending, with the increased size of bank deposits being affected by the increased reserve requirement to the point where the money multiplier results in price stability.

If this system is used in a real economy, I am certain that an ever-increasing reserve requirement will not be needed. Nor will the system result in hyperinflation or deflation, assuming that the reserve requirement is set at a level whereby monetary supply meets monetary demand.