Subsidize the Supernotes. And the Others Too.30th August 2018
In a provocative essay, J.P. Koning argues that the U.S. government should issue supernotes—in denominations of $500 and $1,000. His proposal stands in sharp contrast to those offered by the demonetization crowd, which would see existing large denomination notes scrapped entirely and small denomination notes replaced with bulky coins. Koning claims supernotes would preserve the “ability of U.S. paper money to provide censorship resistance, data protection, and to act as the globe’s back-up monetary system” as inflation continues to erode the real value of the dollar. He also attempts to appease demonetizers by subjecting these supernotes to a supertax, which might be levied at the point of redemption.
I completely agree with Koning in the abstract. There are good reasons to issue supernotes. And, if these supernotes are primarily used to break just laws and to evade optimal taxes, it makes sense to tax them at a higher rate than lower denomination notes. When it comes to the real world, however, Koning and I part ways. Although I agree that the U.S. government should issue supernotes, I believe taxing these notes at a higher rate is unjustified. Supernotes (along with all other denominations) should be subsidized, in the form of a steady and gradual deflationary policy, under which nominal prices would tend slowly to decline over time.
For starters, it is anything but clear that large denomination notes are primarily used by criminals and tax cheats. Let’s start with the high-end estimate offered by Ken Rogoff in his 2016 book, The Curse of Cash (Princeton University Press), which I have described at length elsewhere. Rogoff claims 39 percent of all U.S. notes in circulation are employed by criminals and tax cheats in the domestic economy. The Federal Reserve reports $1,571.1 billion worth of U.S. notes in circulation in 2017, of which $1,251.7 billion was in $100 bills. If we assume that criminals and tax cheats only use $100s, Rogoff’s high-end estimate implies that roughly 49 percent of $100s in circulation facilitate illegal transactions in the domestic economy.
If, instead, we were to take the larger estimates Rogoff reports for currency held abroad (70 percent) and what is admitted to being held by domestic consumers in surveys (10 percent), the estimated shares of all cash and of 100s employed by criminals and tax cheats in the domestic economy fall to just 14 and 18 percent, respectively. And, if one suspects that some law-abiding cash users under-report their cash holdings in surveys—perhaps to keep those balances secure or because they are especially concerned with financial privacy—or that criminals and tax cheats use lower denomination notes as well, the estimates fall further still.
Even if one takes the high-end estimate offered by Rogoff at face value, it is important to realize that some crimes are welfare-improving. We do not live in a world where only just laws make it onto the books. Some laws are bad laws. And circumventing bad laws is good for society.
Paying an undocumented immigrant to mow your lawn, clean your house, or watch your kid is illegal. But it is also a mutually beneficial exchange with no obvious externality. If taxing supernotes discourages these kinds of transactions, society is worse off than it otherwise would be.
The stakes are even higher for those living under repressive regimes. “Money is coined liberty,” Fyodor Dostoyevsky observed, “and so it is ten times dearer to a man who is deprived of freedom.” It might be illegal to bankroll an opposition newspaper or purchase supplies for a peaceful protest. But it is certainly not immoral. Indeed, to the extent that the proposed supernotes undermine illiberal governments, they should be subsidized—not taxed.
How about tax evasion? As I have explained elsewhere, the social costs of tax evasion, which stem mostly from the misallocation of resources, are relatively small. Moreover, there is an offsetting benefit to tax evasion: it limits the extent to which governments can overtax. Tax evasion, like circumventing unjust laws, is especially important for those living under repressive regimes. Supernotes would give citizens around the world a peaceful way to express their discontent with climbing tax rates—a way that their profligate governments would have no choice but to acknowledge.
Taxing supernotes is not a narrowly tailored policy to deal with the social welfare reducing criminals and tax cheats in our midst. Such a tax does not discriminate among users. It is akin to spanking all of your children when one of them misbehaves. Sure, the criminals and tax cheats are punished by the tax on supernotes. But all of the well-behaved users are punished too. And, as I have argued above, there would likely be a lot of well-behaved users.
The case against taxing supernotes at a higher rate is even stronger when one realizes that the tax on existing notes is already too high. As Koning points out, inflation is a tax on cash. And, as with any other tax, it prompts users to switch to less desirable alternatives to avoid the tax. That is a problem. If we are holding too little cash, we are less well-equipped to make transactions. Some transactions—and the gains from those transactions—will go unrealized as a result.
In a much-cited article, Milton Friedman argued that setting the rate of return on cash equal to the rate of return on risk-free bonds would induce people to hold the optimal quantity of money. Today, the real rate of return on a 1-month Treasury bill is around 0.45 percent. Hence, Friedman’s analysis suggests that the optimal tax on currency is not 2 percent, the Fed’s current inflation target, but something in the neighborhood of negative 0.45 percent.
Koning’s proposal to issue supernotes taxed at a higher rate than lower denomination notes is half right. The U.S. government should issue supernotes. A century of inflation under the Federal Reserve means that the largest denomination notes in circulation today can purchase a fraction of the goods they would have commanded a hundred years ago. To match the buying power of a $100 bill in 1918, we would need a note equivalent to around $1,714.21 today. The $500 and $1,000 notes proposed by Koning would go a long way toward bridging that gap. They would preserve the currency’s ability to promote financial privacy and offer refuge to those living under repressive regimes.
Taxing supernotes at a higher rate than lower denomination notes, however, is unwarranted. Indeed, there is a strong case for subsidizing all notes in circulation—setting the rate of return on cash equal to the rate of return on risk-free bonds, as Friedman recommended. Such a policy would not require cutting checks to users at the point of redemption. Rather, the Federal Reserve need merely commit to a policy of mild, productivity-driven deflation. Subsidizing notes in this manner would also negate the need to issue even larger denominations—super-duper notes—in the future.
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