Do Taxes and Bonds Finance Government Spending?

By Bell, Stephanie | Journal of Economic Issues, September 2000 | Go to article overview

Do Taxes and Bonds Finance Government Spending?


Bell, Stephanie, Journal of Economic Issues


Debates over the impacts of various ways of financing government deficits and about the relative impact of monetary and fiscal policy have, unfortunately, been carried out without recognition of the institutional process by which modern government spending, borrowing, and taxation are accomplished. [1] In the United States, close cooperation between the Treasury, the Federal Reserve System, and depository institutions makes the traditional distinctions between monetary and fiscal policy hard to use in describing actual processes and renders irrelevant many of the theories about the most appropriate mix of borrowing and taxation. Indeed, the entire treatment of taxation and of government borrowing assumes a monetary system 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 Treasury and the Federal Reserve coordinate policies that are neither purely fiscal nor purely monetary and to argue that theories of monetary/fiscal policy should inco rporate more discussion of the issues of reserve management.

The "Reserve Effects" of Taxing and Spending

Before examining the reserve effects of various Treasury operations, it is, perhaps, prudent to begin by looking closely at aggregate member bank reserves. [2] Beginning with the Federal Reserve's balance sheet, equivalent terms can be added to each side, and the entries can be manipulated algebraically in order to isolate member bank reserves. [3] The result, often referred to as the "reserve equation," depicts total member bank reserves as the difference between alternative sources and uses of reserve funds. The reserve equation can be written as seen in Figure 1.

From Figure 1, it is clear that an increase in any of the bracketed terms on the left will increase reserves, while an increase in any of the bracketed terms on the right will reduce them.

"Reserve Effects" of Taxing and Spending

In this section, the reserve effects of two important Treasury operations--government spending and taxing--will be analyzed. To emphasize the impact of these operations on bank reserves, the case in which all government payments and receipts are immediately credited/debited to accounts held at Reserve banks will be considered. [4]

When the government spends, it writes a check on its account at 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 amount of the check) as the Federal Reserve debits the Treasury's account, decreasing the right-hand bracket in 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 Treasury account at a Federal Reserve bank is deposited with a commercial bank. Government spending, then, increases aggregate bank reserves (ceteris paribus).

When, instead of drawing on its account at the Fed, the Treasury receives funds into this account, the reverse is true. For example, if a taxpayer pays his/her taxes by sending a check to the Internal Revenue Service (IRS), his/her bank and the banking system as a whole, lose an equivalent amount of reserves, as the IRS deposits the check into the Treasury's account at the Federal Reserve. Total member bank reserves decline as the right-hand bracket in Figure 1 increases. Thus, the payment of taxes by check results in a system-wide decrease in member bank reserves (ceteris paribus). [5]

If Treasury spending out of its accounts at Federal Reserve banks were perfectly coordinated with tax receipts deposited directly into the Treasury's accounts at Reserve banks, their opposing effects on reserves would offset one another. That is, if the government ran a balanced budget with daily tax receipts and government spending timed to offset one another, there would be no net effect on bank reserves. However, as Figure 2 shows, the Treasury's daily receipts and disbursements from accounts at Reserve banks can be highly incommensurate. …

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Do Taxes and Bonds Finance Government Spending?
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