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
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J JOURNALOF ECONOMICISSUES
Vol. XXIV No. 3 September2000

Do Taxes and BondsFinanceGovernmentSpending?

StephanieBell

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 institutionalprocess by which modem govern-
ment spending, borrowing, and taxation are accomplished.1In the United States,
close cooperationbetween the Treasury, the Federal Reserve System, and deposi-
tory institutionsmakes the traditionaldistinctionsbetween monetaryand fiscal pol-
icy hard to use in describing actual processes and renders irrelevant many of the
theories about the most appropriatemix of borrowingand taxation. Indeed, the en-
tire treatmentof taxationand of governmentborrowingassumes a monetarysystem
quite unlike that of the modern U.S. system. My purpose in this paper is to de-
scribe, in some detail, the way in which the Treasuryand the Federal Reserve coor-
dinate 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 Spending

Before examining the reserve effects of various Treasuryoperations, it is, per-

haps, prudentto begin by looking closely at aggregatememberbank reserves.2 Be-
The 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 Centerfor Full Employmentand Price Stabilityis
grateftly acknowledged. Helpful commentsfrom Victoria Chick, John F. Henry, Peter Ho, Anne
Mayhew, Edward Nell, Alain Parguez, James Tobin, Randy Wray, and twaoanonymousreferees greatly
improvedthe argumentsmade in this paper.

603
604 StephanieBell

ginning with the Federal Reserve's balance sheet, equivalentterms can be added to
each side, and the entries can be manipulatedalgebraicallyin order to isolate mem-
ber 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.

"ReserveEffects" of Taxingand Spending

In this section, the reserve effects of two importantTreasuryoperations-gov-

ernment spending and taxing-will be analyzed. To emphasize the impact of these
operations on bank reserves, the case in which all governmentpayments and re-
ceipts are immediatelycredited/debitedto accounts held at Reserve banks will be
considered.4
When the governmentspends, it writes a check on its accountat the Federal Re-
serve. 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 in-
crease in member bank reserves results whenever a check drawn on a Treasuryac-

Figure 1. The Reserve Equation

Sources Uses

Federal Reserve Credit: Currencyin Circulation

U.S. Gov't Securities +
Loans to MemberBanks U.S. TreasuryBalance at
Fed
Total Float +
Member Bank = + Foreign Balances at Fed
Reserves Gold +
+ TreasuryCash
SDR Certificates +
+ OtherFed Deposits and
TreasuryCurrency accounts (net)
 Do Taxes and Bonds Finance GovernmentSpending? 605

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 depos-
its the check into the Treasury'saccountat the FederalReserve. Total memberbank
reserves decline as the right-handbracketin Figure 1 increases. Thus, the payment
of taxes by check results in a system-wide decrease in member bank reserves (ce-
teris paribus).5
If Treasuryspendingout of its accountsat FederalReserve banks were perfectly
coordinatedwith tax receipts depositeddirectly into the Treasury's accounts at Re-
serve banks, their opposing effects on reserves would offset one another. That is, if
the governmentran a balancedbudgetwith daily tax receiptsand governmentspend-
ing 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 sub-
stantial, given that total member bank reserves average only about $50 billion
[Meulendyke 1998, 145]. Thus, a one-day decline in total reserves-to $44 bil-
lion-amounts to a 12 percentdecrease in memberbank reserves. Such a sharp de-
cline is likely to result in an immediatebiddingup of the federal funds rate.
Thus, despite an attenuationof the reserve effect due to the simultaneousinjec-
tion and withdrawalof reserves, governmentspendingand taxationwill never per-
fectly 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&LAccountsand Debt Management)
@1
c
0
-1000.0

L
1~
000
~~~~~~... .ExpendituresSeii
L---Series2
K
4000 ~eceipts .. eis
u- 2000-
0 0
0 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
IL

Source:DailyTreasuryStatement,
http://fedbbs.access.gop.gov/dailys.htm
606 StephanieBell

able to process the returns."Thus, while concurrentgovernmentspendingand taxa-

tion 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 "ReserveEffect"

The inability to perfectly coordinateTreasuryreceipts and expenditureshas seri-

ous implications for the level of bank reserves and, subsequently,the money mar-
ket. 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 de-
sired/required(ceterisparibus). The fed funds marketis the "marketof 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 banking system that began
with an "equilibrium"level of reserves short of required(and/or desired) reserves.
Banks will look to the funds marketto acquire needed reserves, but since all banks
cannot return to an "equilibrium"reserve position by borrowing federal funds, a
system-wide shortage will persist. That is, like a system-wide surplus, a system-
wide deficiency cannot be alleviated through the funds market;attempts to do so
will simply drive the funds rate higher and higher.6
Importantly,the funds rate is not the only interestrate affected by changes in the
level of bank reserves. As the "focusof monetarypolicy, " the funds rate is the "an-
chor for all other interest rates" [Poole 1987, 11]. Thus, when banks are content
with their reserve positions, Treasuryoperations(such as governmentspendingand
taxation) disrupt these positions by adding or drainingreserves, and banks react to
these changes by first turningto the funds market.There, the funds rate is bid up or
down, and other short-terminterest rates are affected. Although some individual
banks will be successful in eliminatingtheir own reserve deficiencies/excesses, the
banking system as a whole will not be able to alleviate a shortage/deficiencyon its
own. Only throughgovernmentadding/drainingof reserves can a system-wide im-
 Do Taxes and Bonds Finance GovernmentSpending? 607

balance be eliminated. Because attemptsto resolve system-wide reserve "disequili-

brium"throughthe funds marketcan affect a numberof other interest rates, a vari-
ety of procedures has been developed to mitigate the adverse impact of Treasury
operationson banks' reserve positions.

Strategiesfor Reducing the Reserve Effect

In the preceding discussion, the effects of governmentspending and taxing on

bank reserves were examinedby assumingthat all disbursementsand receipts were
immediately credited/debitedto the Treasury's accounts at Federal Reserve banks.
This treatmentallowed us to highlightthe impactof each of these operationson the
level of bank reserves, but it did not paint a realistic picture of the way things cur-
rently work. If things did indeed work this way, there would be an unrelentingdis-
ruption of banks' reserve positions and, subsequently,chronic turmoil in the funds
market. Because these consequencesare highly undesirablefrom a policy perspec-
tive, some importantstrategieshave been developed to mitigatethese persistent, yet
unpredictable,reserve effects.

The Use of Tax and Loan Accounts

The disruptivenatureof the Treasury'soperationswas recognized under the In-

dependent Treasury System7 and ultimately led to the use of General and Special
Depositories,8 which are private banks in which governmentfunds could be kept.
This was the first importantstrategy developed to mitigate the reserve effect. As
John Ranlett recognized, the reserve effect caused by the "pointinflow-continuous
outflow natureof Treasuryactivities"could be temperedby placing certain govern-
ment receipts into tax and loan accounts at private depositories [1977, 226]. Thus,
the reserve drain that would otherwise accompanypayments made to the govern-
ment could be temporarilyprevented.9The benefits of using these depositorieswere
quickly recognized, and their functions were broadenedwhen it became clear that
they could be used to furthermitigate the reserve effect. As the size of the govern-
ment's fiscal operationsgrew, Special Depositoriesquickly became the most impor-
tant group of bank depositories [Auerbach 1963]. As Figure 3 shows, just over
two-thirds of all Federal tax receipts are currentlydeposited directly into tax and
loan accounts.
Today, the tax and loan accounts are by far the most importantdevices used to
guard the money market against the sizable daily differences (shown in Figure 2)
between the flows of governmentreceipts and disbursements.
608 StephanieBell

Figure 3. Disposition of Federal Tax Deposits (November 1997-March 1998)

FederalReserve
Other Account(Direct)
2% 13%
RemittanceOption
Depositaries
18%

Taxand LoanNote
Accounts
67%

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

Managing the Treasury'sBalance at the Fed

Since almost all governmentspendinginvolves writing checks on accountsat the

Fed, virtually all funds in tax and loan accounts must eventually be transferredto
Reserve banks.10 Because only net changes in the Treasury'saccountat the Fed im-
pact the aggregate level of reserves (ceteris paribus), maintaining"the Treasurer's
balance with the Reserve Banks at a reasonablyconstantlevel" is the second strat-
egy used to minimize the reserve effect of the Treasury's operations [Auerbach
1963, 364]. Specifically, the Treasury "aimsto maintaina closing balance of $5 bil-
lion in its Federal Reserve checking accounts each day" [Manypennyet al. 1992,
728]. The trend line fitted to the data in Figure 4 shows how successful the Treas-
ury is in its endeavor to maintainthis target closing balance. With the exception of
mid-January,one of the major (quarterly)tax dates, and mid-Novemberand mid-
March, when a variety of taxes are withheld from businesses, the closing balance
fluctuatesonly moderatelyaroundthe $5 billion targetlevel.
Recall that the government receives funds into its accounts at the 12 Reserve
banks as well as thousandsof commercialbanks each day, but that nearly all gov-
ernment spending is done by writing checks on accounts at Reserve banks. Main-
taining a closing balance of $5 billion at Reserve banks, then, usually requires
transferringthe appropriateamountfrom tax and loan accountsto the Treasury'sac-
count at the Fed. For example, if the Treasury expected to receive $5 billion di-
rectly into accounts at Reserve banks (today) and expected $6 billion in previously
issued checks to be presented for payment (today), $1 billion would need to be
 Do Taxes and Bonds Finance GovernmentSpending? 609

Figure 4. Daily Closing Balance in Treasury's Account at the Federal Reserve

(November 1997-March 1998)

? 20,000-

5 10,000 v W' ___1\0%.

.d
_7- - A~
Q ~ ~~ ~ ~ ~~~~~~~1 ,,cv

0
o w N O t CD a c

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

transferredto the Treasury's account at the Fed (today) so that there would be no
net change in the level of reserves.
The Treasury transfersfunds to cover anticipatedshortfallsby making a "call"
on tax and loan accounts. In most cases, advancenotice is given before transferring
funds from these accounts.11A "reverse-call"or "directinvestment"is also possi-
ble. This would be necessary if the Treasuqr'sclosing balanceat Reserve banks was
expected to substantiallyexceed $5 billion. To avoid the reserve drain that would
result from an excessive closing balance, the Treasurymay place some or all of the
excessive funds into tax and loan accounts at Special Depositories (a.k.a. note-op-
tion banks). Whether"calling"fundsfom tax and loan accountsto make up for an
expected shortfall or transferringfunds to tax and loan accounts throughdirect in-
vestment (or canceling previous calls) to prevent an excessive closing balance, the
amounts transferredare intended to maintain the Treasury's balance at Reserve
banks as steady as possible. In pursuitof this goal, the Treasuryrelies on the coop-
erationof the Federal Reserve.

Coordinationwith the Federal Reserve

The Federal Reserve is extremely interestedin helping the Treasuryachieve its

targetclosing balance, because the Treasury'sbalanceat the Fed "is the reserve fac-
tor that shows the most variationfrom one reserve maintenanceperiod to another"
[Meulendyke 1998, 156]. Indeed, the Fed's ability to successfully conductmonetary
policy (specifically, to hit its target funds rate) depends, to a large extent, on the
610 StephanieBell

Treasury's ability to hit its target closing balance. Daily contact between the Treas-
ury and the Fed provide the Treasurywith "numerousoccasions . . . to assist the
Reserve authoritiesto achieve a desired objective"[Auerbach1963, 328].
Unfortunately,the Treasuryis unable, even with the cooperationof the Federal
Reserve, to completely offset the effects of its daily spending using tax and loan
calls and direct investment. Indeed, as Table 1 shows, the Treasury's average
monthlyclosing balance can differ substantiallyfrom its $5 billion target.
This, again, is the result of the inherentuncertaintyregardingthe size/timing of
receipts and expenditures.While it is easy to see how this uncertaintywould prevent
daily inflows and outflows from offsetting one another,Table 1 shows that even on
an average monthly basis, the Treasury's balance can close as much as 31 percent
above its target level. Thus, as Figure 5 confirms, one expects a non-zerochange in
the Treasury's daily closing balance. Despite this, changes in the daily closing bal-
ance do tend to fluctuate fairly closely aroundzero, deviating most drasticallywith

Table 1. (Give this a short, descriptive title)

Month AverageClosing Balance($ Millions)

November 1997 5,015
December 1997 5,371
January1998 6,563
February1998 5,118
March 1998 5,763
Five-MonthAverage 5,618
Source:DailyTreasuryStatement,http://fedbbs.access.gop.gov/dailys.htm

Figure 5. Change in Daily Closing Balance (November 1997-March 1998)

10,000
= 8,000
> 6,000
4,000
2,000
O__ 0A A-
-2,000
~)-4,000
Z -6,000
. -8,000
05 ' OC LO 0 t ( DC CY
Source: Daily Treasury
Statement,http://fedbb.acsgop.n co

Source: Daily TreasuryStatement,http://fedbbs.access.gop.gov/dailys.htm

 Do Taxes and Bonds Finance GovernmentSpending? 611

quarterlytax payments (January,April, June, and September)and with the collec-

tion of withheldbusiness taxes.
In sum, three importantpoints have been made regardingthe Treasury's opera-
tions. First, the Treasuryrecognizedthe disruptivenatureof its cash operationsand
responded by maintainingaccounts at private depositories. Second, the Treasury
uses these accounts to diminishthe reserve effect of its operationsby using tax and
loan calls and direct investmentsto minimize the net changes in Reserve account
balances (to coordinate the flow of its receipts with its expenditures).Finally, the
Treasury and the Fed cooperate to bring about a fairly high degree of harmonyin
managingthe Treasury'sbalancesat Reserve banks.

Bondsto Coordinate
SeUling the Treasury'sOperations

So far we have addressedonly the Treasury'sattemptsto balance its taxing and

spending flows in order to minimize the reserve effect of its operations.Implicit in
our discussion, therefore,was the notion thatthe governmentattemptsto balance its
budget. What if it doesn't? That is, what if the governmentruns a budget deficit?
How does the sale of bonds affect the Treasury's cash flow operations and, sub-
sequently, the reserve effect? There are three scenariosthat must be analyzed in or-
der to determine the reserve effect of selling bonds, the key being by whom and
how are they purchased.
First, it must be recognized that tax and loan accountsactually receive not only
proceeds from tax payments, but also funds from the sale of government debt.
When commercial banks with tax and loan accounts (or customers of these banks)
purchasegovernmentbonds, there may be no immediateloss of reserves to the pur-
chasing bank or the banking system. If, when the Treasuryauctions new debt, it
specifies that at least some portionof the bonds are eligible for purchaseby credit to
tax and loan accounts, Special Depositoriesmay acquirethe bonds by crediting de-
posits (in the name of the U.S. Treasury). These depositories, therefore, will not
lose reserves as they purchase newly issued bonds.F4Similarly, the purchase of
newly issued governmentdebt by a customerof a Special Depository, as long as the
Treasury specifies that some (or all) of the offering is eligible for purchaseby tax
and loan credit, will leave reserves unaffected.For example, when a customer of a
Special Depository purchases government securities, the Treasury redeposits the
check into the bankon which the check was drawn. The bankthen credits the Treas-
ury's tax and loan account, offsetting the debit to the buyer's account. Thus, like the
purchase of governmentdebt by a Special Depository, the sale of governmentdebt
to a customer of one of these institutionscan be effected without any loss of re-
serves.
The second method concerns the private purchaseof newly issued government
debt that does not involve creditinga tax and loan account. When the securities are
612 StephanieBell

ineligible for purchaseby tax and loan accountcredit and/or are not purchasedby a
so-called "note-option"bank (or one of its customers), the purchaseof government
bonds will immediatelydrain reserves from both the bank and the banking system.
This is because the proceeds from the sale of the securitieswill not stay "in the sys-
tem," but will be deposited directly into one of the Treasury'saccountsat a Federal
Reserve bank. When bonds are sold in this way, memberbank reserves decline as
the Federal Reserve credits the Treasury's account, increasing the right-hand
bracketin Figure 1. Thus, a bank wishing to purchaseU.S. governmentsecurities,
when tax and loan credit is not an option, will do so by drawing on its account at
the Federal Reserve. A system-wide loss of reserves will, therefore, accompany
every private purchase of newly issued government debt not eligible for payment
throughtax and loan credit.
Finally, the sale of Treasury securities to the Federal Reserve must be consid-
ered. If the Fed purchasesnewly issued bonds directly from the Treasury,it will not
cause a change in memberbank reserves. This, as Figure 1 makes clear, is because
both the right-hand bracket (U.S. Treasury Balance at Fed ) and the left-hand
bracket (U.S. GovernmentSecurities ) increase by the same amount, leaving total
reserves unaffected. Furthermore,since the government'sbalance sheet can be con-
sidered on a consolidatedbasis, given by the sum of the Treasury'sand Federal Re-
serve's balance sheets with offsetting assets and liabilities simply canceling one
anotherout [Tobin 1998], the sale of bonds by the Treasuryto the Fed is simply an
internal accounting operation, which provides the government with a self-con-
structedspendablebalance. Although self-imposedinstitutionalconstraintsmay pre-
vent the Treasuryfrom creatingall of its deposits in this way, there is no financial
constraintto prevent it from doing so. 15
Now, the Treasuryclearly has choices regardingthe mannerin which newly is-
sued bonds will be sold. For example, if the governmentplans to engage in deficit
spending, the Treasury can sell bonds, allow them to be purchasedby tax and loan
credit, and thereby eliminate any immediateimpact on reserves.16 When the Treas-
ury sells bonds in this way, the bonds act as a sort of ex ante coordinationtool.
Since the Treasurycan control the size and timing of funds transferredfrom tax and
loan accounts, this type of bond sale helps the Treasuryto drain (more or less) the
same numberof reserves from the system that are being addedto the system as a re-
sult of its deficit spending.17
If, however, there is a problemwith the coordination(for example, if the Treas-
ury and Fed underestimatethe amount of checks that are drawn on the Treasury's
accountat the Fed), bonds could be sold in orderto drainexcess reserves.18In other
words, insufficient tax and loan calls (which result in a system-wide increase in re-
serves and threatento send the overnight lending rate to a zero percent bid) could
prompt the sale of bonds as an ex post coordinationtool. In order to immediately
 Do Taxesand Bonds Finance GovernmentSpending? 613

drain the excess reserves, banks could not be allowed to purchase the bonds by
creditinga tax and loan account, but this is somethingthe Treasurycan specify.

The Nuances of ReserveAccounting

The purpose of this section is twofold. First, the commonly held belief that the
purpose of collecting taxes and selling bonds is to provide the governmentwith the
financialresources that fund its expenditureswill be examined. The questionwill be
addressed intuitively,drawingon the reserve effects analyzed in the first three sec-
tions of the paper. Second, for those who remainunconvincedby the intuitiveanaly-
sis, the question as to whether the proceeds from taxes and bond sales are even
capable of financing government spending will be considered. The argument re-
quires an application of basic accounting principles to an analysis of reserve ac-
counting in order to determine whether it is possible to use the revenues from
taxationand the sale of bonds to finance the government'sspending.
There is surely no doubt that the proceeds from taxationand bond sales are de-
posited into accountsheld by the U.S. Treasury(eitherwith commercialbanks or at
the Federal Reserve) and that the governmentspendsby writing checks on Treasury
accounts at Reserve banks. Moreover, since funds are transferredfrom tax and loan
accounts to the Treasury'saccountat the Fed in order to cover anticipatedshortfalls
in these accounts, it certainly looks as though the purpose of taxing and selling
bonds is to fund expenditures.This coordinationundoubtedlysupportsthe belief that
taxes and bond sales are necessary sources of governmentrevenue. But the coordi-
nation of taxationand bond sales with (deficit) spendingis actuallya somewhat dif-
ferent operation.
An intuitive analysis of Treasuryoperationssuggests a practical motivation for
the coordinationof taxationand bond sales with governmentspending. Specifically,
because of the reserve effects of taxing, spending, and selling bonds, the govern-
ment chooses to coordinate these operations in order to mitigate the impact on
banks' reserve positions and, hence, on short-terminterest rates. This interdepend-
ence, then, is not defacto evidence of a financingrole for taxes and bonds.
Similarly, the governmentneed not borrow from the private sector by issuing
bonds in order to enable it to spend in excess of currenttaxation.This, again, is be-
cause the governmentcan always create its own spendablebalance internally(on its
consolidatedbalance sheet) by offsetting a Treasuryliability against a Federal Re-
serve asset (e.g., but not necessarily, a Treasurybond). In the absence of private
bond sales, deficit spending would result in a net increase in aggregate bank re-
serves. Bonds, then, are used to coordinatedeficit spending, draining what would
otherwise become excess reserves. Govermnent debt provides the private sector
with an interest-earningalternativeto non-interest-bearinggovernmentcurrency, al-
lowing the governmentto spend in excess of taxationwithout driving the overnight
614 StephanieBell

lending rate down. Thus, taxes can be viewed as a means of creatingand maintain-
ing a demand for the government'smoney, while bonds, which are used to prevent
deficit spending from flooding the system with excess reserves, are a tool that al-
lows positive overnight lending rates to be maintained.Their coordination,it is ar-
gued here, is undertakenfor pragmaticratherthan "financial"reasons.
There is a danger that this argumentmay be viewed as pure semantics. This is
not so. That is, while it is certainlyappropriateto consider taxationand bond sales
as part of the process of governmentfinance, the implicit treatmentof money, in its
physical form, being transferredfrom the private to the public sector results in a
misleading treatmentof taxes and bond sales as necessary sources of government
revenue. In a world where money has been effectively divorced from commodities,
and where public and private sectors can vary the amountof money to be spent, this
naive way of thinkingcan be highly deceptive.
That such a treatmentcould have gone uncontestedfor so long is, perhaps, sur-
prising. Indeed, some readersmay resist acceptingthe claims made in this paper on
the grounds that they would, were they correct, have been made long ago. But there
have been a number of earlier critics who, although they did not undertakea de-
tailed analysis of the institutionalworkings of governmentfinance, reached similar
conclusions. Abba Lerner, for example, argued that "taxingis never to be under-
taken merely because the governmentneeds to make money payments"[1943, 40].
He furtherrecognized that the governmentshould sell bonds "only if it is desirable
that the public should have less money and more governmentbonds, for these are
the effects of governmentborrowing,"adding that "thismight be desirableif other-
wise the rate of interest would be reduced too low" [1943, 40]. Thus, the main
points made in this paper were made long ago, but they did not succeed in over-
throwingexisting theories regardingthe natureof governmentfinance.
Perhaps this was because Lerner, who attemptedto persuadehis opponentson
logical grounds alone, providedno evidence to supporthis claims. A more compel-
ling case can be made, it is arguedhere, throughan applicationof simple account-
ing. The argument is a technical one and requires an understandingthat Federal
Reserve notes (and reserves) are booked as liabilities on the Fed's balance sheet and
that these liabilities are extinguished/dischargedwhen they are offered in paymentto
the state. It must also be recognized that when currency or reserves returnto the
state, the liabilities of the state are reduced,and high-poweredmoney is destroyed.
The destructionof these promises is no differentfrom the private destructionof
a promise once it has been fulfilled. In otherwords, when a bankmakes a loan to an
individual, it results in a promise to the bank. Once the promise is kept (i.e., the
loan is repaid), the loan debt is eliminatedfrom the borrower'sbalance sheet. Like-
wise, the state, once it fulfills its promise to accept its own money (high-powered
money) at state pay-offices, eliminatesan equivalentnumberof these liabilities from
its balance sheet.
 Do Taxes and Bonds Finance GovernmentSpending? 615

Thus, while bank money (MI) is destroyed when demanddeposits are used to
pay taxes, the government'smoney, high-poweredmoney, is destroyedas the funds
are placed into the Treasury's account at the Fed. Viewed this way, it can be con-
vincingly arguedthat the moneycollected from taxationand bond sales cannotpossi-
bly finance the government'sspending. This is because in order to get its hands on
the proceeds from taxationand bond sales, the governmentmust destroy what it has
collected. Clearly, governmentspending cannot be financed by money that is de-
stroyed when received in paymentto the state.
How, if not by using the money received in payment of taxes and bond sales,
does the governmentfinance its spending?Notice that the governmentwrites checks
on an account that does not comprise part of the money supply or high-powered
money, but that when it does, the fundsbecome partof the money supply (Ml if de-
posited into checking accounts, M2 if into savings accounts, etc.) and part of the
monetarybase. It is therefore apparentthat while the paymentof taxes destroys an
equivalentamountof money (MI immediatelyand high-poweredmoney as the pro-
ceeds go into the Treasury'saccountat the Fed), spendingfrom this accountcreates
an equivalent amount of new money-both bank money and high-poweredmoney.
In short, the governmentfinances all of its spending throughthe direct creation of
new (high-powered)money.

Summaryand Conclusions

If the government(Fed and Treasury)had no regard for the "reserveeffect" of

its operations, it would have little use for tax and loan accounts. It could simply cre-
ate its own spendable deposit (on its consolidated balance sheet) and then spend
without regard for the size/timing of its tax receipts. But this behavior would fre-
quently leave a bankingsystem which was previously satisfied with its reserve posi-
tion, with substantiallymore excess reserves than it wished to maintain. A system
flush with excess reserves would find few biddersfor these funds, and the overnight
lending rate would fall towardzero. Taxes, as they driftedin, would draina portion
of the excess reserves. Still, the funds rate could remainat a zero percent bid for a
prolongedperiod of time.
In order to move to any positive funds rate, either the Federal Reserve or the
Treasurywould be forced to sell bonds to drainexcess reserves. Banks, not wishing
to hold an excessive amount of non-interest-bearinggovernmentmoney, would be
all too happy to exchange non-interest-earningreserves for interest-bearingTreasury
bonds. The bonds would have to be sold until enough excess reserves had been
drainedto yield a positive (target) funds rate. Although this process of adding and
later drainingreserves could work, it would involve substantialvariationin the level
of reserves and, subsequently,significant turmoil in the market for federal funds.
Knowing that these are the undesirableeffects of disregardingthe reserve effects of
616 StephanieBell

its operations, the Treasury chooses to coordinateits operations, transferringfunds

from tax and loan accounts (drainingreserves) as it spends from its account at the
Fed.
Taxes are not capable of financinggovernmentspendingwhen they are paid us-
ing high-powered money (i.e., by cash or check in a fiat money system). In order
for the government to get its hands on the proceeds from taxation, it must place
these funds into the Treasury's account at the Fed. As it does, the banking system
loses an equivalent amount of desired and/or requiredreserves (either immediately
or as the Treasury transfers the proceeds from tax and loan accounts into its ac-
counts at Reserve banks), and an equivalentamount of high-poweredmoney is de-
stroyed. Similarly, reserves are drained, and high-powered money is destroyed
when the Treasuryissues bonds (immediatelyif tax and loan credit is not allowed or
with a lag as the proceeds are transferredfrom tax and loan accounts). In contrast,
government spending from the Treasury's account at the Fed injects reserves and
creates an equivalent amount of new money (MI, M2, etc., and high-powered
money).
It is impossible to perfectly balance (in timing and amount)the government'sre-
ceipts with its expenditures.The best the Treasuryand the Fed can do is to compare
estimates of anticipatedchanges in the Treasury'saccountat the Fed and to transfer
approximatelythe correct amountto/from tax and loan accounts. Errorsdue to ex-
cessive or insufficient tax and loan calls are the norm. Althoughsame-daycalls and
direct investments are designed to permit the authoritiesto react to these errors,
they are not always an option.
When the Treasuryis unable to correct these errors on its own, the Federal Re-
serve may have to offset changes in the Treasury's closing balance. This will be
necessary whenever the errors are large enough to move the funds rate away from
its target rate. In fact, as argued previously, the uncertaintyfaced by monetary
authoritiesis often primarilydue to uncertaintyregardingthe Treasury'sbalance at
the Fed. Its role as an offsetting agency is essentially forced upon it by its commit-
ment to a target funds rate. Indeed, William Poole [1975] goes further, stating that
the Fed will usually abandon any other objective target in order to maintain the
funds rate within its tolerance range. The adding/drainingof reserves, then, is
largely non-discretionary,as monetarypolicy is concernedprimarilywith maintain-
ing the overnight lending rate. Fiscal policy, in contrast,has more to do with deter-
mining the supply of high-poweredmoney than is usually acknowledged.Moreover,
while both taxation and bond sales drain reserves from the banking system, neither
provides the government with money with which to finance its spending. Indeed,
both taxation and bond sales lead (ultimately) to the destructionof high-powered
money.
In addition to a reconsiderationof taxation and bond sales as financing opera-
tions, perhaps it is time to reassess the definitions of monetaryand fiscal policy.
 Do Taxes and Bonds Finance GovernmentSpending? 617

Fiscal policy has more, and monetarypolicy less, to do with the money supply than
is usually recognized. An analysis of reserve accountingreveals that all government
spending is financedby the direct creation of high-poweredmoney; bond sales and
taxationare merely alternativemeans by which to drain reserves/destroyhigh-pow-
ered money. The debate over alternative "financing"methods, then, should really
be a debate over the alternativemethodsfor drainingreserves (taxes vs. bond sales)
in order to prevent the overnight lending rate from falling to zero. As Lerner ar-
gued, it is not so-called "sound"but "functional"finance that moderngovernments
should practice, and this means using taxes and bonds "simplyas instruments,and
not as magic charms that will cause mysterioushurt if they are manipulatedby the
wrong people or withoutdue reverencefor tradition"[1943, 51].

Notes

1. Early debates [Modigliani 1961; Blinderand Solow 1973, 1976; Barro 1974; Buiter 1977;
Lerner 1973; Tobin 1961] over the optimal method by which to finance deficit spending
remain a controversial topic today [Trostel 1993; Ludvigson 1996; Smith and Villamil
1998]. Despite differing beliefs about the macroeconomicconsequences of, say, borrow-
ing vs. "printingmoney," economists on both sides of these debatesclearly accept that the
purpose of collecting taxes and selling bonds is to secure funds that are then respent by the
government. In other words, it is generally agreed that the role of taxationand bond sales
is to transfer financial resources from households and businesses (as if transferringactual
dollar bills or coins) to the government, where they are respent (i.e., in some real sense
"used"to finance government spending). This erroneous view follows from an implicit
treatmentof money in its physical form and can be avoided by considering the balance
sheet and reserve effects of taxationand bond sales. This, in short, is the purpose of this
paper.
2. Although reserve requirementsare generally met by holding a combinationof vault cash
and checking accountsat districtFederalReserve banks, accountsheld by depositoryinsti-
tutions at Federal Home Loan Banks, the National Credit Union AdministrationCentral
LiquidityFacility, or correspondentbanks may also count toward satisfyingthe reserve re-
quirement. Depository institutionsdo not have to meet these reserve requirementson a
daily basis. They have a two-week "reserveperiod"(endingon Wednesdays)within which
they must maintainaverage daily total reserves equalto the requiredpercentage of average
daily transactionsaccounts held during the two-week period ending the preceding Mon-
day. Thus, despite being referredto as a contemporaneousreserve accounting(CRA) sys-
tem, it is, in practice, lagged for two days. That is, banksalways have two days (Tuesday
and Wednesday)within which to acquire (ex post) reserves needed to eliminate a known
deficiency. While some banks may choose to hold excess reserves, profit-maximizing
banks will economize on reserves. Unless a bank has a preference for idle funds, it will
exchange excess reserves for "earningassets" such as loans or securities.
3. See Ranlett [1977, 191-1931for the derivation.
4. It is, of course, true that the Treasury keeps accounts at thousandsof commercial banks
and other depository institutionsas well as Federal Reserve banks. This changes things
considerablyand will be takenup in the next section.
5. It is worth noting that governmentspending must originally have preceded taxation. That
is, the payment of taxes could not increase the Treasury's account at the Fed (Figure 1,
right-handbracket), reducing bank reserves, until the reserves had been created. More-
618 StephanieBell

over, the Federal Reserve and/or Treasury, as the only agents capable of supplyingthem,
must have been the original source of these reserves. This will be taken up in the section
titled TheNuances of ReserveAccounting.
6. When there is a reserve deficiency for the bankingsystem as a whole, banks could attempt
to resolve the deficiency by reducingdeposits. If a single bank begins this process (selling
U.S. securities to a member of the non-bankpublic or allowing loans to be repaidwithout
reissuing them), it will result in a multiplecontractionof deposits (assumingall banks fol-
low suit). Though this would ultimatelyeliminatethe banking system's reserve deficiency
(without requiringbanks to acquire additionalreserves), the process takes time and will
disruptinterest rates until "equilibrium"is restored. Deficiencies thereforewill usually be
eliminatedas the bankingsystem acquiresmore reserves, not as it reduces depositsthat re-
serves are requiredto "backup."
7. The IndependentTreasury System was in effect long before the establishmentof the Fed-
eral Reserve System. It was established in 1840, abolished the following year, re-estab-
lished in 1846, and discontinuedin 1921.
8. General Depositories have become known as "remittance-option banks,"while Special De-
positories are currentlyreferredto as 'note-optionbanks."Both are depositoryinstitutions
with tax and loan accounts, but a "remittance-option bank," like its predecessor, the Gen-
eral Depository, must remit its tax and loan accountbalancesto a Reserve bankthe day af-
ter the funds are received. In 1978, note-option banks were given the opportunityto
accumulatethe daily tax paymentsthey receive by transferringthem from the ordinarytax
and loan accounts (where they are held interest-freefor one day) into an interest-bearing
"noteaccount." Up to a pre-approvedlimit, these funds can remainin "noteaccounts"un-
til the Treasury "calls"for them to be transferredto Reserve Banks [Manypennyand Ber-
mudez 1992, 728].
9. In this case, a distinctionbetween the "supplyof money" and high-poweredmoney (bank
reserves and currency outstanding)should be made. When tax receipts are placed into a
tax and loan account, high-poweredmoney is not affected. The narrowmoney (MI), how-
ever, is. When funds are transferredfrom demand deposits, where they are part of M1,
into tax and loan accounts (or the Treasury's accountat the Fed), which is not part of any
standardmeasureof the money supply (MI, M2, etc.), the "moneysupply"declines.
10. This is not because the government needs the proceeds from taxation in order to spend
again, but because it chooses to coordinateits taxing and spending. This will be taken up
in the final section.
11. Special Depositories (or note-optionbanks) fall into three categories: A banks, B banks
and C banks. A and B banks are typically smaller institutions,while depositoriesthat are
classified as C banks are generally large banks. Tax and loan calls are calculatedas frac-
tions of the book balance in each tax and loan account on the previous day. "Calls"made
on A and B banks are usually made with longer lead times than calls made on C banks,
and the latter are usually the only banks against which same-dayor next-day calls may be
issued.
12. The closing balance in the Treasury's account at the Fed could exceed the target level for
two reasons. First, previously placed tax and loan calls may have been too large. In this
case, the amount of spending from accounts at Reserve banks is less than the sum of the
paymentsreceived directly into accountsat the Fed and the amounts "called"from tax and
loan accounts. Second, it is possible that the paymentsmade to the governmentand depos-
ited directly into accounts at Reserve banks exceed the amount presented for payment
from these accounts. This could happen, for example, during months in which quarterly
tax payments sent directly to accounts at the Fed are large enough to more than compen-
sate for governmentspending.
13. The Treasurywill not, in all instances, be successful in its attemptto directly invest its ex-
cess funds. Some note-optionbanks will not meet the collateral requirementsand will be
 Do Taxes and Bonds Finance GovernmentSpending? 619

ineligible recipients of additionaltax and loan funds. Additionally,tax and loan accounts,
like the Treasury's account at the Fed, may swell during unusually heavy quarterlytax
payments. Because banks must pay intereston tax and loan accounts, they limit the size of
the tax and loan balances they are willing to accept. When direct investmentis not an op-
tion, the Treasury can attemptto cancel previously scheduledcalls in an attemptto draw
down its balance in Reserve banks.
14. The reader might wonder whetheradditionalreserves are requiredas a result of the larger
tax and loan balance. The answer is no. Since the establishmentof interest-bearingnote
accounts in November 1978, Special Depositories have been free of reserve requirements
againsttax and loan deposits.
15. The Federal Reserve was, for a time, prohibitedfrom purchasingbonds directly from the
Treasury. This changed during World War II, when the Fed was authorizedto purchase
up to $5 billion of securities directly from the Treasury. Since then, the limit has been
raised several times.
16. Boulding [1966] notes that deficit spendingmost commonly involves this practice.
17. Note that the government can deficit spend without taxing or selling bonds first, but if
government spending is greater than taxation, the bankingsystem will be left with excess
reserves. The Treasury, therefore, prefers to use bonds to coordinateits deficit spending,
selling them to Special Depositories (and allowing tax and loan credit) before spending
from its accounts at Reserve banks. The bonds, then, allow the governmentto defend (ex
ante) the fed funds rate.
18. Note that bonds would have to be sold even if the governmentran an annually balanced
budget. This is because it is impossibleto eliminatethe "reserveeffects" of the Treasury's
daily operations. Thus, swings in the Treasury's daily closing balance, which threatento
move the funds rate away from its target, would induce the sale of bonds despite an annu-
ally balancedbudget.

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