Avoiding the word “tax”

I have a new way to balance the budget. When employees are paid, I will require their income to spend one day in an escrow account, where it will be invested in “Liberty Bills”. Liberty Bills are government-issued bonds with a daily return of negative 5%. I am confident that this simple reform will eliminate the deficit.

Of course, you might argue that I’m effectively just hiking income taxes by 5%. You’d be right! “Escrow accounts” and “Liberty Bills” are just a needlessly complicated way for me to impose an income tax. Only someone incredibly naive would think that my policy was substantively different from an income tax, right?

Maybe not. In fact, I see similar proposals all the time.

Consider the following: when Dean Baker proposes that we cancel the Treasury debt held by the Fed, he’s essentially saying (aside from the temporary accounting gimmick) that we should undertake a long-term shift in the composition of debt, from bonds to money. Why? Most observers suspect that the Fed will eventually pull back the money created through quantitative easing. To so, however, it needs to sell lots of assets—and if half of its assets disappear, this is no longer a viable option. Under Baker’s proposal, then, the Fed will be forced to leave over $1 trillion in excess reserves in the system, until it recapitalizes through profits (far in the future) or is bailed out by Congress (in which case the proposal is completely circular). Debt that would otherwise be issued by the Treasury will be left in the form of money instead.

What happens then? Quite possibly nothing. With so many reserves in the system, the premium on reserves will linger around zero—no one will sacrifice yield to hold reserves when equivalent riskless assets are available. The rate paid on reserves, the federal funds rate, and the short-term T-bill rate will all be roughly the same. In this environment, issuing debt in the form of money rather than bonds is completely useless: you can borrow at the same rate with T-bills. Monetization changes nothing.

What Baker proposes, however, is to vastly increase the burden of reserve requirements, such that there is no longer an excess supply of reserves. At this point, banks are willing to pay a premium for reserves, the Fed is able to pay interest on reserves at a rate lower than the rate on T-bills. Money becomes a cheaper form of finance than bonds, and we see a fiscal benefit.

But what’s really happening? The Fed saves money in this scenario only because the new reserve requirements force banks to carry a low-yield asset (reserves) in order to accept deposits. In other words, the Fed is taxing bank deposits. In fact, Congress could impose precisely the same tax through legislation: a statutory tax of (federal funds rate – interest on reserves)*(reserve requirement) would be equivalent.

Of course, hardly anyone* wants us to enact an ad-hoc tax on certain types of bank deposits: it’s not a very efficient way to raise money, and it’s quite possibly regressive. I can easily think of a dozen more effective ways to boost revenue. So why does anyone take this proposal seriously? As far as I can tell, it’s because a “reserve requirement” doesn’t sound like a tax. It’s not obvious that this policy is just another distortion-inducing way to gather revenue, and that it should be subject to the same cost-benefit analysis as any tax. As with many proposals for means testing, we’re so eager to escape uncomfortable fiscal tradeoffs that we invent a new, needlessly circuitous way to tax, one that’s even less efficient than the existing tax code.

I’m still fond of Liberty Bills myself.


*As I mentioned in my last post, there are serious proposals for taxing “liquidity creation”, but properly implementing these proposals would produce a policy so different from today’s reserve requirements that it’s a stretch to use the same name.

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6 Comments

Filed under fiscal, macro

6 responses to “Avoiding the word “tax”

  1. I can easily think of a dozen more effective ways to boost revenue.

    Can you? It’s certainly true that, if the scale of revenue-raising is large, it would be inefficient to do all of it by taxing a small part of the economy. But on the margin, I don’t really see how bank deposits are much more useful than anything else we might choose to tax — except of course for things that are actually harmful. If we’re going to have a tax increase, I think a tax on banking, such as the equivalent one you mention, would actually be relatively popular compared to most of the alternatives (in part, admittedly, because many of the people who will end up paying it don’t understand tax incidence). But reserve requirements are also special in that, unlike other taxes, they can be imposed by regulatory fiat. So it isn’t just the label that’s important. As a person who would ultimately like to see the government have more revenue and is somewhat concerned about the political feasibility of raising revenue through the legislative process, I think raising it by regulatory fiat is not a bad idea.

    To tell the truth, I have my doubts as to whether the commercial banking system is really an efficient way to allocate capital, given the instability inherent in demand deposits, so it’s not clear to me that even a very large increase in reserve requirements would be inefficient relative to the likely alternatives.

    • If the reserve requirement was modified enormously to cover repo, commercial paper, and all other forms of liquidity creation, I think that the implicit tax might not be such an inefficient way to raise money. This would represent a very dramatic change, however, one that would require an enormous amount of regulatory legwork and quite possibly some additional legislation. (Admittedly, I’m not familiar with the specifics.)

      Anything short of this would probably be a disaster—there would be a tax imposed on more stable retail banking but not on shadow banking, which appears to be the main source of instability in practice.

      Moreover, if we are going to tax liquidity creation, I would prefer doing it in a stability-enhancing way. Imposing an implicit tax through a larger reserve requirement doesn’t really do this—after all, the “reserves” used to satisfy a mandate are not really “reserves” in a conventional sense. (You can’t burn through them as a source of emergency liquidity, because that puts you in violation of the mandate, unless it’s suspended.) They also don’t lessen the likelihood that a bank will become insolvent.

      Higher capital requirements, on the other hand, directly lessen the risk of insolvency and financial catastrophe. They’re viewed as “expensive” by bankers (in apparent violation of Modigliani-Miller) in large part because the tax code privileges debt over equity. Thus a large component of the additional “cost” of capital requirements actually goes to the government; conditional on the existing tax code, they constitute an implicit tax.

      Given the many other benefits of capital requirements, I view them as far superior to reserve requirements as a combined play to (1) impose a Pigouvian tax on the financial sector and (2) actively limit the risk in the financial sector.

  2. Andy: there is an old argument that the inflation tax (of which this is just a variant) is always more distorting than (say) an income tax. That’s because there are 2 margins distorted by the inflation tax: the standard money/bonds “shoe-leather” margin; *plus* the work/leisure margin. You can avoid the inflation tax by not working (so you won’t need to hold as much money), as well as by running to the bank more often.

    For example (pax Matt, this is just for a simple illustration!) assume velocity is fixed at 1. Then a 10% inflation tax is equivalent to a 10% income tax.

    • Thanks for pointing this out. I don’t think this (completely valid) logic applies to paper currency—as I mentioned in a footnote to my hit job on the Friedman rule, it is doubtful that paper currency bears such a direct relationship with consumption or economic activity. The quantitatively dominant reasons for holding it—illegal activity, tax evasion, store of value in other countries, mild dislike of debit or credit cards—are too idiosyncratic to generate the “distortion along two margins” result you mention.

      The result feels much, much more plausible, however, when we’re talking about bank money in general. My original intuition was somewhat different but similar—since bank deposits (taken broadly) constitute a very important chunk of savings, a large reserve requirement would distort both (1) the consumption/savings decision (compounding the strong preexisting distortions and generating a “tax interaction effect”) and (2) the decision about how to allocate savings across assets. Alternatively, we could view bank deposits more as “money” (necessary for income or consumption) and get distortion along both the “shoe-leather margin” (which in this case might be called the “carpal tunnel syndrom margin”, since the real effort is in transferring money between accounts) and the labor/leisure margin, as you mention above.

  3. vimothy

    Of course, you might argue that I’m effectively just hiking income taxes by 5%. You’d be right! “Escrow accounts” and “Liberty Bills” are just a needlessly complicated way for me to impose an income tax. Only someone incredibly naive would think that my policy was substantively different from an income tax, right?

    Aha–I believe that I’ve just asked basically this same question in the comments to your previous post! I shall consider myself answered.

  4. What’s happened to the posts? 😦

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