The real function of taxes

Taxes are dumb.

It's hard to be controversial to say so. Most people who worked and earned money for a living would be frustrated by the whole experience that is so embedded in modern society, to the point it becomes something we learned to be helpless about.

This post won't try to change the way taxes work. I'm too small of a player for the legal system to give a damn about. ¹

That said, I can explain how taxes work in a way that the common person will learn, and people can decide if taxes are worth it.

Modern monetary theory

Modern money is all fiat, meaning it is not backed by anything. Not gold, not oil, just blind trust. Actually, it is backed by the power of military², but we will leave the story to another day.

If we are to accept that money is not backed by anything, a state theoretically doesn't need to collect taxes before they spend -- they can just spend on what they want and pay it back later by raising taxes, or to do nothing and devalue all cash and savings.

"Why bother collecting taxes?"

Great question. The amount of effort it takes to collect taxes is enormous.

Using the US as an example (its the most available one to build my priors) the estimates of tax compliance cost of the $546 billion, or nearly 2 percent of GDP.

Annually, the US government raises 17% of GDP as taxes.

In effect, we are spending $15 for every $100 we harass a productive business to give the state.

This number includes taxes paid through active means (IRS audits) and passive means (taxes on income, VAT). If we are to estimate the cost of active collection and the actual tax revenue active collectors raised, it may be less than the cost it takes to finance active collectors.

It's like spending $100 on debt collectors (debt isn't even a right word as it implies we owe the state our production) to raise something less than $100.

If the objective of taxes is really to raise capital to afford projects, active collection seems ineffective at what they do.

Instead of answering why are we doing something inefficient, let's start with what happens if we just do nothing.

Case 1: Really doing nothing

No government spending, no taxes, constant supply of money. The state is literally sleeping at the wheel.

Unrealistic scenario, but suppose this happens we should predict inflation to be 0%. This seems like a time when we have a perfect currency.

The problem is that the economy becomes perfectly competitive, which means those that earn will hold more currency and control a bigger share of the network (mercantilism).

The currency becomes less representative to those who are weaker or less competitive. With no state spending, there is no safety net except for private charities.

If people expect spending will cause them to lose power to sellers, then transactions are seen as zero-sum and the economy gets more illiquid.

Also, not having a state is really a bad idea, in the sense that markets become lawless. In practice what you'll end up getting is local mafias bullying businesses into giving them special privileges -- you don't pay taxes to the state, but you pay "taxes" to guys meaner than you. ³

Case 2: Doing anything the state wants

State prints as much money as it wants, gives out as much to anyone who will vote for them. Never collects any of them back.

Sounds too good to be true. Now people stop producing because there is no reason to. When there is no production, all the money can't buy anything -- you have a hyperinflation situation.

There's more! When people expect the currency to get weaker, the network of producers becomes more reluctant to accept the currency -- people rather do a barter trade or keep good things for themselves than to take your currency.

Case 3: Spend now, collect back everything later

The "perfect" scenario. The state spends as much as it wants to get something done, then get back all the money it spent back from people through taxes.

No net inflation, and stuff gets done! What's the problem?

There is always a better deal

There is a more perfect scenario -- stuff gets done, and people keep all the newly minted currency. If something valuable was already done, why waste energy to give back the catalyst (ie: the currency)?

The problem happens when the currency gets spent on more things than it was made to spend on (IE: buying labor for social services becomes salary to spend and compete on limited goods) -- Taxes ensures the velocity of created money is not infinite.

In practice people can always argue why they don't need to return the currency, so its hard to take back as much money as we created.

Whose stuff gets done?

The state can create money to buy for things they want, but in practice you can bet the decisions aren't fair (IE: what the state wants to buy might not be what the people want to buy).

In fact, the state can just set up a shell company with their entourage, print some money and pay his friends and declaring his friends are being "paid to do social work". -- This is wastage in a nutshell.

In practice, things are not so blatant. Its more likely for state actors to set up lots of layers of agency that takes some cut of the budget, where the agency also happens to contain a share of the state's entourage -- also known as "deep state".

So a scenario with perfect balance sheet is not perfect if the work paid to do / things bought isn't representative.

Crowding out

If the state prints money to hire workers, then it means someone else would lose the worker they wanted to hire to do their work.

In a free market, the most important work gets done first and that is reflected by prices and bids.

When the state spends money, it is unclear if the work that needs to be done are the most important ones.

When suboptimal decisions are made and financed, in effect that is also a net loss to the people. It's like saying you win 10% doing something when you could have won 50% doing nothing -- a good outcome is not a valid defense for a good decision.

It's all decisions

Notice the theme here. The state can do anything it wants, but its decisions must be sound (IE: logical, benefits the people, within budget).

A sound decision is one that is profitable. IE: You spend little to do a lot.

When the state does something suboptimal, the net effect is the people's standard of living will devalue because they:

1. need to ask more taxes from the people to pay back what they spent.
2. print more money to pay back what they spent, creating inflation.

In modern finance, taxes are paid so inflation does not happen.

"Why not just let inflation happen?"

Great question. If the net effect of ineffective state spending is lower standards of living, and the way it is delivered can be either passive (through inflation) or active (through taxes), we could choose to do nothing.

Why go through all the hassle and trouble to feel pain?

I could write a whole post on how money works, how it flows. But the short answer I discovered after 20 years of studying money is: "it's all politics".

You will never understand bureaucracies until you understand that for bureaucrats procedure is everything and outcomes are nothing. -- Thomas Sowell

While the post is critical about taxes, there are some cases when it can make sense... ^{4 5}

However, rather than trying so hard to raise taxes, there is a better way...

"Stop spending (other people's) money on stupid stuff"

People think public spending is free money. I've already shown you that public spending takes back money through taxes or inflation -- it is just financial physics.

The reason why people think public spending is free money -- that voters consistently vote for money spending across any civilization -- I suspect has to do with "semantic deception".

If people really understood how public spending gets paid back, perhaps they wouldn't be so obsessed with the idea of "free money". The issue is that the sematics "public spending" gives people the idea that it is "money spent on the public", so we just ignored all the little things that happen behind the scenes.

The same "semantic deception" can happen in things like "trust and safety team" ⁶ , "conservative and liberal" ⁷, "as a matter of fact" ⁸.