Unlinking Public Finance and Taxation in a Fiat Currency System

Abstract

It is widely known that in a fiat currency system, governments can create money tokens to meet public expenditure, then take some of them back through taxation or bond issue to adjust the money supply to a desired level. Yet the treasury departments in most countries strive to formulate fiscal policies in an attempt to match taxation with public expenditure while, at the same time, the central banks use monetary policy instruments for regulating money supply. The key question addressed in this research is whether the policies of the treasury departments and central banks are relevant to the functioning of the present-day economies where fiat currency is supposed to facilitate transactions rather than being a commodity. A parsimonious model of the macroeconomic system subsuming also the fiscal and monetary interventions is presented. The model is then used to understand the relevance of taxation to fiat money and to explore alternative policy levers for funding public expenditure and regulating money supply while delinking expenditure from taxation. It is proposed that the public spending can be entirely funded through deficits, while taxation together with open market operations is used as inflation control instruments. Control mechanisms for driving taxation and open market operations are explored.

Keywords: public finance, taxation, tax reform, macro-economics, fiat money, economic growth, system dynamics, computer simulation