TAILIEUCHUNG - Can Taxes and Bonds Finance Government Spending?

This paper investigates the commonly held belief that government spending is normally financed through a combination of taxes and bond sales. The argument is a technical one and requires a detailed analysis of reserve accounting at the central bank. After carefully considering the complexities of reserve accounting, it is argued that the proceeds from taxation and bond sales are technically incapable of financing government spending and that modern governments actually finance all of their spending through the direct creation of high-powered money. The analysis carries significant implications for fiscal as well as monetary policy | Can Taxes and Bonds Finance Government Spending by Stephanie Bell Working Paper No. 244 July 1998 Cambridge University Visiting Scholar The Jerome Levy Economics Institute The author wishes to thank Peter Ho John Henry Edward Nell and Randy Wray for helpful comments. Remaining errors are mine. Abstract This paper investigates the commonly held belief that government spending is normally financed through a combination of taxes and bond sales. The argument is a technical one and requires a detailed analysis of reserve accounting at the central bank. After carefully considering the complexities of reserve accounting it is argued that the proceeds from taxation and bond sales are technically incapable of financing government spending and that modem governments actually finance all of their spending through the direct creation of high-powered money. The analysis carries significant implications for fiscal as well as monetary policy. 1 INTRODUCTION The optimal method by which to finance government deficit spending remains a controversial topic among many economists see Modigliani 1992 Trostel 1993 Ludvigson 1996 and Smith et al. 1998 . Although most would agree that government financial policies require choosing among the imposition of taxes the sale of interest-bearing debt obligations and the printing creation of government money1 or some combination of these there is often strong disagreement regarding the macroeconomic consequences of these choices. The Barro-Ricardo thesis Barro 1974 for example suggests that the financing choice is inconsequential. This it is argued is because the knowledge that bond-financed government spending will require higher taxes in the future induces households to save more now. The induced saving which is just sufficient to purchase the new government debt leaves private net wealth unchanged thereby completely neutralizing the stimulative effect of government spending. Similarly as Tobin recognizes spending financed by issuing demand .

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