Taxation of Fiat Money Using Dynamic Control

Abstract

The treasury analogy is widely used in most countries in the execution of fiscal policies striving to match taxation with public expenditure while, at the same time, the central banks tinker with interest rates and reserve requirements and conduct open market operations for regulating money supply. This paper investigates the relevance of those policy actions to the ubiquitous use of fiat money tokens which in addition to meeting public expenditure and paying taxes also facilitate transactions in the economy. A parsimonious model of the macroeconomic system subsuming the prevalent fiscal and monetary interventions is developed and experimented with to explore alternative policy levers for funding public expenditure and controlling money supply. A novel dynamic control regimen to regulate taxation and open market operations for controlling inflation is proposed. It is shown that while the public spending can be entirely met through new money creation, taxation and open market operations must be used as inflation control instruments, whereas expenditure instruments can be used to alleviate the regressivity of taxation regimen.