Federal Taxes: They Aren’t Funding Federal Spending

Since it is tax season, I want to again discuss how federal taxes work. But this time, a little bit more in depth. I wish to demonstrate the concept of federal taxation by pretending that I am the federal government and that there are three people in the non-government sector, Bob, Patty and Jane. Afterwards, we will discuss where your tax dollars actually go and why you pay federal taxes.

Bob owes $1,000 in taxes and has $5,000 in his bank account. Jane will be receiving a refund of $8,000 and has $2,000 in her bank account, Patty will be paying a tax of $3,000 and has $20,000 in her bank account.

First, let’s total all of the US dollars currently in our three person non-government sector so far.

$20,000 + $2,000 + $5,000 = $27,000 in the non-government sector.

Now, I, the US government, will go into Bob’s account and tax him:

The Bank Account of Bob
Balance: $4,000

There. I simply adjusted his numbers down 1,000. He’s been taxed. How? I just deleted the number 1,000. That’s all. No waiting for an armored truck to deliver $1,000 in cash. I went into his bank account, saw the number 5,000 and said to myself, “Ok, 5,000 – 1,000 = 4,000” and changed his balance down to reflect the answer. It’s all just simple subtraction. Now, let’s tax Patty:

The Bank Account of Patty
Balance: $17,000

After adjusting Patty’s balance down by $3,000, she has been taxed. Lastly, let’s make sure that Jane gets her refund:

The Bank Account of Jane
Balance: $10,000

There we are. After going into Jane’s account and adjusting her numbers up by 8,000, she now has a balance of $10,000. Where did the $8,000 come from? Nowhere. I simply typed the number reflecting the answer to the addition problem 2,000 + 8,000 = 10,000, stuck a “$” symbol in front of the number and suddenly, $8,000 exists. Hey, I am the US government. Only I have the power to turn numbers into currency. So, let’s look at the results. First, we will find out how many US dollars are now in the non-government sector.

$4,000 + $17,000 + $10,000 = $31,000 net savings of the non-government sector.

I taxed Bob $1,000 and Patty $3,000. When summed together, the total tax collections are $4,000. Meanwhile, I issued $8,000. So, I, the US government, ran a deficit and added $4,000 more to the non-government sector for it to net save. Had I not taxed anyone and gave Jane her refund anyway, there would be a deficit of $8,000 and so, there would now be a net savings of $35,000 in the non-government sector instead of $31,000. But where did the $4,000 that I taxed go?

Where does the number 4,000 go when you subtract 4,000 from, say 5,000 on a calculator? You type the number “5,000” then you hit the subtract symbol, then you type the number “4,000” and hit the equals symbol. The number 4,000 changes to “1,000”. 4,000 was there a moment ago and now it is gone forever. Yes, I know. Easy to understand when you use a calculator, hard to fathom when it comes to US dollars. But it shouldn’t be. It’s the same thing, just a little more complex as there is a certain procedure going on in the background, which we will learn about shortly. In the case of federal spending, you need to understand that the actual US dollars do not sit in your bank account. They exist in a reserve account at the Fed. What is in your bank account, once you make a deposit, is just a bunch of numbers that reflect the amount of US dollars that you hold. In other words, your bank account is a record.

A Quick Banking Operations Primer

Commercial banks like Chase and Bank of America have what are called reserve accounts at the Federal Reserve. The purpose of these accounts is not to enable these banks to make loans. They help the payments system operate properly. In these accounts are actual US dollars that, contrary to popular belief, are never “released” into the economy when loans are made. Please ignore Paul Krugman. He doesn’t know what he’s talking about. These US dollars always stay at the Federal Reserve.

So, you see, the US dollars in reserve accounts at the Federal Reserve never enter the economy. They always remain at the Federal Reserve and shift between the various reserve accounts of other banks, as payments go through, thus ensuring that payments clear.

As an example, let us assume that you have a checking account at Chase and you write a check for $100 to someone who has an account at Bank of America. When they deposit your check at Bank of America and the check clears, $100 shifts from Chase’s reserve account held at the Federal Reserve to Bank of America’s reserve account held at the Federal Reserve. So, Chase’s reserves drop by 100 and Bank of America’s rise by 100. Consequently, the balance in your checking account at Chase drops by 100 reflecting the shift in reserves and the person’s bank account at Bank of America rises by 100.

Also, banks cannot be deficient in reserves. If they are, they must obtain them for a price on the interbank market, or go to the Fed’s discount window and pay an even greater fee. The Federal Reserve stands ready to ensure that banks have the requisite reserves necessary to ensure that the payments system functions. When a bank goes to the discount window, the Federal Reserve emits HPM (High Powered Money) into the reserve account of the bank and charges the bank a fee for this. In layman’s terms, the Federal Reserve creates US dollars out of thin air and credits the bank’s reserve account with those dollars and charges the bank a fee for requiring the service. Banks who are deficient prefer to obtain reserves on the interbank market. At this point, you need to understand what happens when banks compete for reserves in the interbank market.

The competition for reserves can drive the overnight rate towards the floor, or in layman’s terms, it can cause the overnight rate to drop. This causes serious problems for the Federal Reserve which sets target interest rates and must defend them. If the Federal Reserve sets a target interest rate above zero and interbank competition drives the overnight rate down below the Fed’s target rate, the Federal Reserve must act to drain off the excess reserves by swapping a treasury bond for the excess reserves before it loses control of its target interest rate. Keep this in the front of your mind, because you are about to learn where federal tax dollars go.

The Federal Reserve Is Not a Private Bank

When the US government spends, it is crediting bank accounts somewhere with numbers. When it deficit spends, the process could result in excess reserves in the banking system. The US Treasury and the Federal Reserve work together in cooperation to operate the US monetary system. The Federal Reserve isn’t a private bank. It is the nation’s central bank and it is part of the US government. Its membership is comprised of private banks. They aren’t “owners”, they are members of the Federal Reserve system. I hate to use such a juvenile example to point out this reality, but look:
www.federalreserve.gov <--- See the “.gov” part? Go ahead. Click the link. It will take you to the Federal Reserve’s website where you will learn that the Federal Reserve is not a private bank:

“Who owns the Federal Reserve?

The Federal Reserve System fulfills its public mission as an independent entity within government. It is not “owned” by anyone and is not a private, profit-making institution.
As the nation’s central bank, the Federal Reserve derives its authority from the Congress of the United States. It is considered an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms.

However, the Federal Reserve is subject to oversight by the Congress, which often reviews the Federal Reserve’s activities and can alter its responsibilities by statute. Therefore, the Federal Reserve can be more accurately described as “independent within the government” rather than “independent of government.”

The 12 regional Federal Reserve Banks, which were established by the Congress as the operating arms of the nation’s central banking system, are organized similarly to private corporations–possibly leading to some confusion about “ownership.” For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.”

The above is from the Federal Reserve’s website FAQ, which you can read here: http://www.federalreserve.gov/faqs/about_14986.htm The US Treasury and the Federal Reserve comprise what we call the Consolidated Federal Government of the United States. Yes, the Federal Reserve makes mistakes in setting policy. So does Congress. What’s new? Anyway, back to federal taxation.

Reserve Maintenance Procedures

The US Treasury maintains what are known as TT&L accounts (Treasury Tax and Loan accounts) that it holds in commercial banks. These banks sit outside of the government sector. They are private banks. Most of the time when taxes are paid, the numbers shift from the many bank reserve accounts at the Fed to the reserve accounts of these banks which are also held at the Fed. The US Treasury will at some point remove these dollars from those reserve accounts to its own account at the Federal Reserve. When it does this, those dollars exit the banking system. But why do this if the federal government is not using the tax dollars to fund spending? Here’s why.

The US government deficit spends by having the Federal Reserve create HPM (remember HPM from earlier?) or in layman’s terms, US dollars. The US government does not need an income to do this, as US dollars are just numbers with a “$” symbol, so it does not need the “money” in TT&L accounts first before it can spend. In fact, there are numbers with a “$” symbol in these TT&L accounts, because the US government had spent those dollars into existence at some point previously.

Now, recall, the Federal Reserve must maintain its target interest rate. Deficit spending is necessary to add dollars to the non-government sector and it could result in an increase of the amount of reserves if the US government didn’t tax at all, or relevant to our discussion, it continuously spent more than it taxed and didn’t remove tax dollars from these TT&L accounts.
If there are excess reserves system-wide and the banks who have them try to lend them on the interbank market during a time when no banks want them, this would cause the overnight rate to move out of range of the Fed’s target rate and in turn, cause the Fed to lose control unless it intervenes to drain off excess reserves with treasury bonds. The Federal Reserve would have to repeatedly sell treasury bonds over and over again non-stop, in an attempt to defend its target interest rate, until it ran out of bonds. Out of breath and bonds, the Federal Reserve would then call the US Treasury and say, “What are you trying to do here? Just remove some tax dollars from the TT&L reserve accounts!” If it refused to do so, the US Treasury would then be forced to issue more bonds just to continue draining off excess reserves, thus prompting “The Colonel” from Monty Python to interrupt the nonsense saying, “Stop that! Stop it! I’ve noticed a tendency for monetary policy to become extremely silly. Far more silly that it already is. Now then, let’s get some decent policy done. On my cue, the Fed will maintain a zero interest rate policy and the US Treasury will stop issuing bonds. Cue a reliance on fiscal policy… Wait for it! Cue fiscal policy… Now!”

Incidentally, here we also see the true function of treasury bonds: They conduct monetary policy – they drain excess reserves. When a bond is sold, US dollars are removed from the reserve account and substituted with that bond. In other words, bonds are swapped for excess US dollars in reserve accounts. To make this point very clear, if there is $1,000 in a reserve account and you swap $500 in liquid US dollars for a $500 bond, then the new composition is:

$500 Liquid + $500 Treasury Bond = $1,000

A treasury bond is just a US dollar that pays interest. Bonds aren’t “loans” to the federal government or “borrowing” by the federal government. For the US Treasury to even issue bonds, US dollars must first exist so they can be purchased. So, there must either be excess reserves present for the banks to buy them, or else the Federal Reserve must issue the US dollars necessary for the bonds to be purchased. This is just like federal taxes. You cannot pay taxes until the US government has spent, because all US dollars come from the US government. Thus, we come to a startling realization about both federal taxes and treasury bonds:

All US dollars used to pay federal taxes and buy treasury bonds come from federal spending.

So, when the US Treasury removes $1 billion from the reserves of the banks where it has TT&L accounts, $1 billion is removed from the banking system thus creating space for more spending and helping the Federal Reserve maintain its target interest rate. Or, to think of it in another way, the US government is doing some housekeeping. That “housekeeping” is what we call a Reserve Maintenance Operation.

On a daily basis, the US government is issuing US dollars, crediting bank accounts (spending) and on a daily basis, it is also taxing away dollars out of the banking system. This process is managed very carefully by both the US Treasury and the Federal Reserve working in cooperation. By shifting reserves out of the banking system, the dollars held in reserves go bye-bye.

US dollars: “We go bye-bye now?”
US government: “Yes. You go bye-bye now.”

So, before the reserve maintenance operation –

TT&L Reserve Accounts:
Balance: $2 Billion

After the $1 billion reserve maintenance operation –

TT&L Reserve Accounts:
Balance: $1 Billion

Space created for more federal deficit spending: $1 billion

As the federal government then proceeds to deficit spend again, bank reserves now have room to build up, rather than risk rising beyond the previous level. In other words, the pitcher has been emptied a bit to make room for more water. And before some of you ask, “Well, what about QE then? It causes excess bank reserves.”- QE is a different matter entirely. QE is an asset swap for liquidity which, yes, builds up bank reserves. But in order for the Federal Reserve to do QE allowing bank reserves to build to excess, interest rates must be at or near zero, otherwise the excess reserves created by QE would only have to be drained away again to maintain the target interest rate. We will discuss QE in another post.

I should point out that the above does not imply that reserve maintenance is the sole function of federal taxation. Federal taxes:
– create a demand for US dollars
– control spending power
– attempt to discourage behavior (cigarette tax)
– allow the federal government to provision itself
– assist with reserve maintenance

One thing they do not do, however, is fund federal spending. The condition is impossible. The US government must first spend so that it can tax the dollars away. Again, taxation is how the US government gets US dollars out of the economy so it can create a space for further government spending and also ensure that the Federal Reserve’s monetary policy stays on target. The federal government looks at its room and says, “Hmmm? Not enough space. If I put anything new in here, the Federal Reserve is going to trip over it. I’ll throw this and this out in the trash. There. Now, I can fit new stuff in that space.”

So, now you understand that when you pay your federal taxes, it isn’t hard cash or some rare commodity that is moving to the Treasury so that Congress can then hand your US dollars to corporations or SNAP recipients. It is just a bunch of numbers shifting around and being deleted from spreadsheets – the US government doing some housekeeping – enabling the US government to properly operate the monetary system.

Anyway, that’s why I did what I did to Bob and Patty.