Is Fiat Money Ultimately Tax Based?

Question

First, I am not an economist, so seeking general "good enough" answers. Since Nixon went off the gold standard the U.S. dollar has been a fiat currency backed by federal debt.

While I understand there will be many complexities, I assume that what "backs" the value of the fiat dollar is faith in the stability of U.S. bonds and the government that issues and repays those debts.

So, this implies to me that the value of the dollar is ultimately based on the stable collection of federal revenues, which is largely based on future taxation, with an increasing percent falling on labor in the form of income taxes.

So, each dollar is a present credit issued on a future debt secured through tax collections. I am trying to sort out some of the socio-economic implications of this. But is there anything in this admittedly very crude description that is fundamentally wrong?

The national currency may be a kind of faith-based consensus and abstract medium of exchange, but it is ultimately based on a faith in the power of government to repay its rotating debt through its main sources of revenue, tax collection, correct? Just trying to make sure I'm not way off the trail here.

Answer 1

First correction of various misconceptions:

Since Nixon went off the gold standard the U.S. dollar has been a fiat currency backed by federal debt.

U.S. dollar is not backed by federal debt, and in general fiat currencies by definition of the word are not backed by anything (see Wallace 2017).

Also, generally if money is backed by something it has to be convertible/redeemable at some fixed rate for that thing. U.S. government does not give you promise to exchange your \$100 note for its bonds upon request. Moreover, if U.S. government would feel like running surplus budget they do not need to sell you any debt instruments either.

I assume that what "backs" the value of the fiat dollar is faith in the stability of U.S. bonds and the government that issues and repays those debts.

Again not generally correct, value of fiat money depends on demand and supply for that money. Depending on what sort of situation regarding government debt we talk about it might affect value of currency or not (see overview of literature on various aspects of sovereign debt in Reinhart and Rogoff (2009), some passages of the source on debt thresholds are outdated and no longer accepted but the overview of literature on sovereign debt crises and defaults is still valid and comprehensive and discusses cases when debt crises led to loss of value of currency and cases when it did not).

Regarding the main question

Is Fiat Money Ultimately Tax Based?

No and yes.

Fiat money by definition is not based on anything else than government decree. However, value of that government issued money will depend on demand for that money and supply of that money.

One important way how governments can artificially create demand for their money is by requiring taxes to be paid in money they issue. Taxes do not necessarily need to be paid in money, in principle they could be settled with in kind payments. However, if state requires you to pay taxes in dollars you always have to make sure you will have some dollars at hand when you need to pay them. Thus you will demand dollars even if you personally may not like them, and everyone else does the same. This creates non-trivial portion of demand for money and that is what gives money its value.

In addition, if government runs surplus and does not spend the money it collects through taxation it also reduces velocity of money in circulation which is tantamount to economy having lower quantity of money, so this would increase money’s value as well.

Sustainability of government finances affects value of money only to the degree it affects supply and demand for money. Moreover, as you can read in Reinhart and Rogoff (2009) empirically more often than not sovereign debt crises are resolved through debt monetization (which increases supply of money), and they are often accompanied by capital flight from a country (which both decreases demand for country's money and to increase in supply of money). This is why countries with debt problems typically end up with money that has low value, not because fiat money is in any meaningful sense backed by government debt.

Answer 2

Fiat means "decree".

William F. Hummel, a retired engineer, in the recent past published articles on money and credit systems. He has since retired from public discourse. This is an entry which discusses the evolution from a gold standard to so-called fiat money in the United States (when the State makes gold or silver coin the metal standard this is also by decree and the contracts for debt specified in terms of metal tokens always exceed the value of metal tokens in circulation so credit and stable government policies drive the modern economy not metal-backed money).

http://wfhummel.net/primer.html

Keynes held that the primary concept in the theory of money is the unit of account. Throughout history, States have established what is to serve as legal tender. They have done so by (1) giving a name to the unit of account; (2) declaring what token is legal tender measured in that unit; and (3) enforcing debts and contracts payable in that token.

The point is that debts and contract prices must be expressed in terms of the unit of account while the token can be whatever the government chooses, and can be changed independent of the unit of account. In the U.S. the unit of account is the dollar, and the token is a dollar bill. When the U.S. established the dollar in 1792, the token was a silver and copper alloy coin weighing 27.0 grams, containing 24.1 grams of pure silver.

The unit of account is given a name and this name appears on the token money along with a number indicating quantity. Contracts for goods, services, and payment of debt are specified in the unit of account and enforced by the Court system. Taxes are a debt owed to the government which creates demand for the official money. If the economy produces many goods, services, and investments that can be purchased with the official money this creates more demand via the concept called "network effects."

In the two-tier bank payment clearing system the Fed ensures banks have enough reserves (federal funds owned by banks) to clear payments among each other and to transact with Fed and the federal agencies of the U.S. government. According to the proponents of Modern Monetary Theory the government must spend money into circulation before it can be withdrawn from circulation in payment of taxes. They say it this way, "Fed must do a reserve-add before it can do a reserve-drain." However in a system where the commercial banks create deposit money from "thin air" via the expansion of credit held in the aggregate bank financial asset portfolio the Fed does not have to create reserves before it drains reserves since the transactions between the U.S. Treasury and the non-bank sector do not add or remove net reserves on average provided the Treasury issues debt to cover the deficit for each period. So there are two theories either Fed must add reserves before any reserve payment back to Fed or Treasury or reserves can circulate for some forms of payment such as when Treasury matches spending to tax collections, other revenue, and sells Treasuries to make up the difference.

Demand for dollar denominated financial assets is proportional to the value added by the economy in terms of real goods and services but also due to the government institutions taking on the obligation to fight rampant inflation or deflationary forces that historically prove to be harmful to the real economy. Faith in the government and market institutions definitely gives value to money in whatever form.