1. All the island dollars that people have came from government spending at one time or another.
2. When the government spends, it increases the net dollar wealth of the world. You can think of government spending as the government printing green pieces of paper and exchanging them for good and services.
3. When the government taxes, it decreases net dollar wealth. You might think of taxation as the government collecting money and dumping it into a shredder.
4. Fiat money has value because it’s the only form of payment accepted for island taxes.
A lot of this probably sounds odd if you're used to thinking about gold backed currency. The goal here isn't to attack or defend fiat currency; rather I just want to explain how it works and how these ideas might affect policy decisions.
As Bob and ESM pointed out in the comments to part 1, in year 1 the government has to spend (or give away) at least as much money as it wants to collect in taxes each year; otherwise people won't have money with which to pay their taxes. ESM went further and said that the government has to spend enough for people to pay their taxes and satisfy their demand for dollar savings.
If the government spends or gives away $6000 per person per year and collects $5000, then people will be able to save $1000/person on average. Some people might save more or less (and some could end up in debt), but $1000 has to be the average.
You should also note that in this example, the government ran a deficit of $1000/person. So each year, the government deficit matches the change in private dollar savings. If the government runs a deficit, then total dollar savings must rise, and if the government runs a surplus, total dollar savings must fall. (This might be the opposite of what you thought previously.)
For this reason, some people (though admittedly, not many) refer to the national debt as "the national savings account". People's total accumulated dollar savings must match the government's accumulated dollar debt. It's a closed system after all.
A few other interesting points about this system:
- The purpose of taxation is not to raise revenue, at least not on the federal level. The island government prints and destroys its own currency, so it can spend however much it wants.
- Of course, printing a lot of money and not destroying very much money can cause the dollar to lose value and trigger inflation. So the real reason for taxation is to reduce the number of dollars floating around to "make room" for the dollars that the government wants to deploy. Another way to say it is that the government taxes in order to reduce aggregate demand and keep prices under control. A second purpose of taxation is to give dollars value in the first place!
- Not everyone has to pay taxes for this set-up to work. Even if only people whose last names began with "A" had to pay taxes, dollars would still have value to Mr. Aaronson. But Mr. Bozo would still value dollars since he knows that Mr. Aaronson values them. In other words, Mr. Bozo is happy to accept dollars as payment for calculus tutoring, since Bozo can then use those dollars to buy stuff from Aaronson. So they'll both value dollars. To pick a more realistic example, U.S. dollars have value to Canadians even though they (typically) don't have to pay U.S. taxes.
Next time: How does government borrowing work? Is printing money the same as borrowing?