Below is an extract from a commentary originally posted at www.speculative-investor.com on 11th June 2006.

If asked the question "why do we have taxation?" most people would probably respond with something along the lines of "the government collects taxes so that it can pay its bills" or "taxes finance the operations of government". However, rather than going through the extremely costly exercise of collecting taxes -- the process of collecting taxes is costly to the government and the steps taken by people to minimise the amount of tax they pay place a large burden on the economy -- the government could simply print all the money it needs.

But wouldn't the printing of all this new money create an inflation problem? The answer is yes, there would be more inflation (money supply growth). However, inflation is really just a surreptitious form of taxation, so if the government were to print all the money it needed then people would be taxed indirectly rather than directly. There would potentially be a net benefit to the economy, though, if all forms of direct taxation were replaced by the surreptitious tax of inflation. This is because all the public and private resources that are presently consumed via the unproductive tasks of collecting and avoiding taxes would be freed up.

It is also worth noting that if money printing replaced direct taxation then the total addition to the money supply would be a lot less than the replaced tax revenue because the government's expenses would be a lot lower. The elimination of the huge government network that exists solely for the purpose of bringing in tax revenue -- something we've already mentioned -- is one reason why expenses would be lower. Another reason is that there would be no federal debt if the government printed whatever money it needed. To give you an idea of what a big difference the elimination of the federal debt would make to the government's annual expenses we'll note that the US Federal Government paid $350B dollars in interest during the 2005 fiscal year and has already paid about $250B in interest during the current fiscal year.

Which brings us back to the question: why do we have taxation?

As far as we can tell there are two inter-related reasons, the first of which can be explained with the help of the following extract from Richard Kelly Hoskins' book "War Cycles Peace Cycles".

"When the crusaders first left their homelands in Europe for the crusade to the Holy Land, they took with them almost the entire circulating supply of gold and silver coins. This left western nations, England in particular, with no money.

In the year 1100 A.D. Henry I, 4th son of William the Conqueror, ascended the throne of England. Finding the treasury empty and his needs great, he cast about for a source of income. Having wise advisors he soon hit on a plan. The plan, with a few refinements, remained in effect for the next 726 years - and can be reinstated tomorrow. He issued "tallies".

A tally was a stick about nine inches or so long with each of the four sides about 1/2 inch wide. On two of the sides, the value of the "tally" was carved into the wood. On the other two sides, the amount was printed in ink.

The tally was then split in half lengthwise. One half remained in the treasury and the other half was given to soldiers for their pay, to farmers for wheat, to armorers for armor, and to laborers for their labor.

At tax time, taxpayers were required to bring in one half of a tally to pay their taxes. Woe unto the man who did not have the required number of tally sticks. As a consequence, these intrinsically worthless sticks of wood were in great demand. Gold and silver coins were fine if you traveled abroad for a crusade or something, but at home if you did not have your tax-tally at tax time - you were done.

Upon receipt of a tally the treasurer would immediately match the presented half with the half stored in the treasury. THEY HAD TO TALLY - which is what gave it the name. Counterfeiters lost their heads! Actually, it was practically impossible to counterfeit a tally. The wood grain had to match - the notches had to match - and the ink inscriptions had to match. This could only come about if both pieces came from the same split tally stick.

There you have it! An inexhaustible source of revenue for the government. The means were available to make tallies as long as there were trees. There was a demand as long as the government required the tallies for taxes. The system flourished as long as tax-evaders and counterfeiters were punished and they always were. For 726 years the system flourished."

In the historical example described above, the government created strong demand for essentially worthless pieces of wood by requiring that all taxes be paid using these formerly worthless objects. Something that would otherwise have had no value hence became valuable. It's a similar story today in that taxes create demand for essentially worthless pieces of paper. For example, if you have a lot of gold, a large dollar-denominated tax bill and a small amount of dollars then you will need to sell some of your gold in order to obtain the dollars needed to pay your tax bill. Even though gold is much better suited to be money than any of today's national currencies and would be a lot more useful to the government than the paper it churns out at almost zero cost, we don't know of any government that would accept gold in payment of a tax bill.

Taxation not only supports the currency directly due to the need to obtain the currency in order to pay the tax, it supports it indirectly by fostering the general belief that the currency is actually worth something. After all, if the government is prepared to accept the currency it creates, and ONLY the currency it creates, in payment of taxes then the currency must have genuine value, right? On the other hand, if the government were to announce that there will be no more taxation and that all future government expenses will be paid by turning on a monetary printing press then light-bulbs would suddenly appear above the heads of millions of people. People who previously hadn't given the nature of modern money a second thought and who hadn't stopped to consider why a piece of paper with the number 100 printed on it should be worth 100-times as much as a similar piece of paper with the number 1 printed on it would quickly come to realise that if the government can just print as much money as it wants then the money must have no real value; a realisation that would lead to the question: why should I work hard for something the government can produce in unlimited amounts at no cost to itself?

In summary, without the underlying demand created by taxation there is a good chance that the purchasing power of today's national currencies would collapse. Taxation is therefore a critical component of the current monetary system, but not for the reasons most people think.