The Income Tax Multiplier

If you haven't heard of the "money multiplier" or "fractional reserve banking" I encourage you to spend a few moments looking at the definition of each at Wikipedia. (See http://en.wikipedia.org/wiki/Money_creation#Money_multiplier and http://en.wikipedia.org/wiki/Fractional-reserve_banking)

Very briefly, it's the process by which banks can expand the money supply because -- as a group -- they are permitted to loan a percentage of the money they have on deposit. The Federal Reserve establishes a reserve ratio, which is about 10%. When a bank gets a deposit of say $1,000, it is allowed to loan as much as $900 to various borrowers. What do the borrowers do with the money? Well, they deposit it in another bank. The second bank is allowed to loan as much as 90% of $900. The third bank in the chain can then loan as much as 90% of $810. And so it goes until the original $1,000 has been expanded by a factor of 10. So the banking system now has $10,000 of deposits from various customers. If the reserve ratio were set at 20%, the multiplier would be 5 to 1 instead of 10 to 1.

But what about the income taxes that are collected by the government on those multiple deposits? Well, it depends on whether the money that is received and deposited is defined as "income" by the tax law.

For example, assume we have an average income tax rate or a flat tax rate of 20%.

Taxpayer # 1 gets $1,0000 of income and he deposits $1,000 in the bank. Then he writes a check for $200 to the IRS. The first bank is now able to make loans of 90% of $800. But wait, The second bank that gets the tax dollars is also able to make loans of 90% of the $200 in taxes. So the banking system still gets to expand the money in circulation by the same amount.

Two taxpayers now borrow the $900 from the two banks that received the money from the first taxpayer and from the IRS. They spend the money on non-deductible personal expenses -- but the people who receive that $900 have to treat it as income. They therefor deposit the $900 in their local banks and then send a combined total of $180 to the IRS.

So the original $1,000 circulates through the economy and expands the money supply by 10 to 1. But the IRS also benefits from the money multiplier because they end up collecting $2,000 -- which is 10 times the original $200 of tax on the initial $1,000 of income.

So the next time you have to pay the IRS $200, you should know that you have actually contributed about $2,000 to the government coffers through the income tax multiplier. ANd if you don't spend the money you borrow on things that generate income tax from the people you pay the money to, then the tax multiplier doesn't work. So if you don't want the IRS to get more money, invest your borrowed money instead of spending it.

Vern