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Bell, Stephanie - Do Taxes and Bonds Finance Government Spending

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Do Taxes and Bonds Finance Government Spending? Author(s): Stephanie Bell Source: Journal of Economic Issues, Vol. 34, No. 3 (Sep., 2000), pp. 603-620 Published by: Association for Evolutionary Economics Stable URL: http://www.jstor.org/stable/4227588 Accessed: 16/07/2010 13:01Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aee. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

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JOURNALOF ECONOMIC ISSUES Vol. XXIV No. 3 September2000

Do Taxes and BondsFinanceGovernment Spending?Stephanie Bell

Debates over the impacts of various ways of financinggovernmentdeficits and about the relative impact of monetaryand fiscal policy have, unfortunately,been carriedout without recognitionof the institutional process by which modem government spending, borrowing, and taxation are accomplished.1In the United States, close cooperationbetween the Treasury, the Federal Reserve System, and depository institutionsmakes the traditionaldistinctionsbetween monetaryand fiscal policy hard to use in describing actual processes and renders irrelevant many of the mix of borrowingand taxation. Indeed, the entheories about the most appropriate tire treatmentof taxationand of governmentborrowingassumes a monetarysystem quite unlike that of the modern U.S. system. My purpose in this paper is to describe, in some detail, the way in which the Treasuryand the Federal Reserve coordinate policies that are neither purely fiscal nor purely monetaryand to argue that theories of monetary/fiscalpolicy should incorporatemore discussion of the issues of reserve management.

The "Reserve Effects"of Taxingand SpendingBefore examining the reserve effects of various Treasuryoperations, it is, perhaps, prudentto begin by looking closely at aggregatememberbank reserves.2 BeThe author is a Ph.D. candidate at The New School for Social Research and a Lecturer at the Universityof Missouri-Kansas City. Thispaper was wntten while the authorwas CambridgeUniversity Visiting Scholar at The Jerome Levy Economics Instituteat Bard College and has been presented at the Post Keynesian SummerConferencein Knoxville, Tennessee, July 1998; the Post Keynesian Graduate Workshopin Leeds, UnitedKingdom, 1998; and at the Conferenceon the Economics of Public Spending in Sudbury, Ontario, 1999. Financial supportfrom the Center Full Employmentand Price Stabilityis for grateftly acknowledged. Helpful commentsfrom Victoria Chick, John F. Henry, Peter Ho, Anne Mayhew, Edward Nell, Alain Parguez, James Tobin, Randy Wray, and twao anonymousreferees greatly improvedthe argumentsmade in this paper.

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ginning with the Federal Reserve's balance sheet, equivalentterms can be added to each side, and the entries can be manipulated algebraicallyin order to isolate member bank reserves.3 The result, often referredto as the "reserveequation,"depicts total member bank reserves as the difference between alternativesources and uses of reserve funds. The reserve equationcan be writtenas seen in Figure 1. From Figure 1, it is clear that an increase in any of the bracketedterms on the left will increase reserves, while an increase in any of the bracketedterms on the right will reduce them. "Reserve Effects" of Taxingand Spending In this section, the reserve effects of two importantTreasuryoperations-government spending and taxing-will be analyzed. To emphasize the impact of these operations on bank reserves, the case in which all governmentpayments and receipts are immediatelycredited/debitedto accounts held at Reserve banks will be considered.4 When the governmentspends, it writes a check on its accountat the Federal Reserve. If, for example, a Social Security check is deposited into an account at a commercial bank, member bank reserves rise (by the amountof the check) as the Federal Reserve debits the Treasury'saccount, decreasingthe right-handbracketin Figure 1, and credits the account of a commercial bank. Thus, a system-wide increase in member bank reserves results whenever a check drawn on a TreasuryacFigure 1. The Reserve Equation

SourcesFederal Reserve Credit: U.S. Gov't Securities Loans to MemberBanks Total Member Bank = Reserves Float + Gold + SDR Certificates + TreasuryCurrency

UsesCurrencyin Circulation + U.S. TreasuryBalance at Fed + Foreign Balances at Fed + TreasuryCash + OtherFed Deposits and accounts (net)

Do Taxes and Bonds Finance Government Spending?

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count at a Federal Reserve bank is depositedwith a commercialbank. Government spending, then, increasesaggregatebank reserves (ceterisparibus). When, insteadof drawing on its accountat the Fed, the Treasuryreceives funds into this account, the reverse is true. For example, if a taxpayerpays his/her taxes by sending a check to the InternalRevenue Service (IRS), his/her bank and the bankingsystem as a whole, lose an equivalentamountof reserves, as the IRS deposits the check into the Treasury'saccountat the FederalReserve. Total memberbank reserves decline as the right-hand bracketin Figure 1 increases. Thus, the payment of taxes by check results in a system-wide decrease in member bank reserves (ceteris paribus).5 If Treasuryspendingout of its accountsat FederalReserve banks were perfectly coordinatedwith tax receipts depositeddirectly into the Treasury's accounts at Reserve banks, their opposing effects on reserves would offset one another. That is, if the governmentran a balancedbudgetwith daily tax receiptsand governmentspending timed to offset one another, there would be no net effect on bank reserves. However, as Figure 2 shows, the Treasury'sdaily receipts and disbursementsfrom accounts at Reserve banks can be highly incommensurate. Indeed, during this short sample period, Figure 2 shows that they can differ by almost $6 billion. This is substantial, given that total member bank reserves average only about $50 billion [Meulendyke 1998, 145]. Thus, a one-day decline in total reserves-to $44 billion-amounts to a 12 percentdecrease in memberbank reserves. Such a sharp decline is likely to result in an immediatebiddingup of the federal funds rate. Thus, despite an attenuationof the reserve effect due to the simultaneousinjection and withdrawalof reserves, governmentspendingand taxationwill never perfectly offset one another. Moreover, even if a more even pattern could be established, some discrepancieswould persist because, as Irving Auerbach [1963, 349] recognized, "thereis no way to determinein advance, with complete accuracy, the total amountof the receipts or the speed at which the revenue collectors will be

Figure2. Daily Flowsinto/fromFederalReserveAccounts,March 1998 (Net of Transfersto/fromT&LAccounts Debt Management) and@1 c 0

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.ExpendituresSeiiK L---Series2..

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3/5 3/9 3/10 3/11 3/13 3/16 3/17 3/18 3/19 3/20 3/23 3/25 3/26 3/27 3/30

Source: DailyTreasury Statement, http://fedbbs.access.gop.gov/dailys.htm

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able to process the returns."Thus, while concurrentgovernmentspendingand taxation have some offsetting impact on reserves, the reserve effect from the Treasury's daily cash operations would still be substantial,especially "if they were channeled immediately through the Treasurer's balance at the Reserve Banks" [Auerbach 1963, 333]. The Importanceof the "Reserve Effect" The inability to perfectly coordinateTreasuryreceipts and expenditureshas serious implications for the level of bank reserves and, subsequently,the money market. Because banks are requiredby law to hold reserves against some fraction of their deposits, but earn no interest on reserves held in excess of this amount, they will normallyprefer not to hold substantialexcess reserves. Governmentspending, then, will leave them with more reserves than they will prefer/needto hold, while the clearing of tax payments will leave them with fewer reserves than are deof sired/required(ceterisparibus). The fed funds marketis the "market first resort" for banks wishing to rid themselves of excess reserves or to acquirereserves needed to meet deficiencies [Poole 1987, 10]. When there is a build-upof reserves within the system, many banks will attemptto lend reserves in the federal funds market. The problem, of course, is that lending reserves in the funds marketcannot help a bankingsystem, which began with an "equilibrium" level of reserves, to rid itself of excess reserves. Moreover, when the system is flush with excess reserves, banks will find that there are no bidders for these funds, and the federal funds rate may fall to a zero percentbid. Likewise, the clearing of tax paymentswill leave a