Where does the government get the money it spends?

The chief way the government gets the money it spends is through taxation. Figure 1 shows the relative sizes of sources of federal government tax revenues. Forty-five percent of federal tax revenue comes from individuals’ personal income taxes. Another 39 percent comes from Social Security and Medicare withholdings. Since half of Social Security and Medicare taxes come directly out of people’s paychecks, about 65 percent of taxes the federal government collects come from individuals. Thirty-two percent of taxes come to the government from corporations. Estate and gift taxes, sources of significant debate, account for only 1 percent of federal tax revenues.

Can’t the government just make money by printing it?

Taxation is not the only way the government raises money. Prior to 1933, the United States was on a gold standard. The amount of gold the government had in its possession limited the number of dollars the government could print. What made the gold standard important was not the gold, but rather the limit on the number of dollars the government could print. A “land standard” or a “fresh water standard” that limited he number of dollars the government could print by the amount of land or fresh water the government owned would have achieved the same effect. The value of the object serving as the standard is not important. What is important is that the object exists in a fixed quantity. As long as the quantity of the object is fixed and the number of dollars is limited by the number of units of the object the government owns, the government will be unable to print as many dollars as it likes. When the government can print as many dollars as it likes, it has the ability to impose an “inflation tax.” In what way is inflation a tax? When the government prints money, prices rise. When prices rise, money loses value. For example, if a tank of gas costs $20, then the $20 bill in your pocket is worth a tank of gas. If the price of gas rises so now a tank costs $30, then the $20 bill in your pocket is only worth two-thirds of a tank of gas. The increase in the price of gas caused the money in your pocket to lose value.

This isn’t only true for the money in your pocket;  it is also true for the money in your bank account. If the government can print money to buy stuff and in so doing cause prices to rise, the resulting increase in prices causes money you own to lose value. The government has effectively taxed you to pay for the stuff it bought.

Consider the following simple example: The money supply is $100,000, the economy produces 100,000 units of stuff each year, and the average price for one unit of stuff is $1. You have $5 in your wallet. With this $5 and with the price of stuff at $1 per unit, you can buy 5 units of stuff. Suppose that the government wants to buy some stuff, but has no money. The government prints $10,000 and uses the newly printed money to buy some stuff. Since the money supply has risen 10 percent and the production of stuff has remained constant, the average price of stuff will rise 10 percent to $1.10. Now, if you want to buy some stuff with your $5, you can only afford about 4.5 units of stuff. In effect, the government has taxed you one-half of a unit of stuff to pay for the stuff it purchased.

The inflation tax is insidious because it is usually unseen (when inflation is moderate, people tend not to notice it and, when they do, fail to appreciate that it is in fact a tax). Furthermore, it is impossible to avoid.  Understanding that inflation is also a tax leads us to a fundamental truth: The only way the government can obtain money is through taxation.