Friday, August 2, 2013

Banking Example #9: Paying Taxes

This reader inspired example simply shows what happens when an individual pays taxes to the Federal government.

Setup: the Treasury Dept. (Tsy), the central bank (CB), a commercial bank (A) and two persons: x and y. Assume that y had owned a house which x purchased exactly as laid out in balance sheet sets 1 and 2 of Example 8. Balance sheet set 2 from that example is repeated here for convenience as our starting point (I number the initial set of sheets below "2" to emphasize this). I also color the balance sheet entries to focus on.

 2. Balance sheets after person x takes a loan from Bank A and buys person y's house with it. (the yellow colored cells are the ones to watch)

Tsy, CB
Assets Liabilities
$0 $0

Bank A
Assets Liabilities
$100k mortgage to x $100k deposit for y

Person x
Assets Liabilities
$100k house $100k mortgage at A

Person y
Assets Liabilities
$100k deposit at A $0
Negative Equity Equity
----------------------- $100k


3. Assume that Person y made a profit on the sale and now owes the Federal government $10k in taxes, and then pays the tax. The resulting balance sheets look like:

Tsy
Assets Liabilities
$10k CB deposit $0
Negative Equity Equity
-------------------- $10k

CB
Assets Liabilities
$10k loan of reserves to A $10k deposit for Tsy
 
Bank A
Assets Liabilities
$100k mortgage to x $90k deposit for y
------------------------- $10k reserve borrowing from CB

Person x
Assets Liabilities
$100k house $100k mortgage at A

Person y
Assets Liabilities
$90k deposit at A $0
Negative Equity Equity
--------------------- $90k


Please excuse the extra complication of two people and a house. I could claim I did that to be consistent with my desire to have most of these examples "net to zero" meaning that if all the balance sheets are consolidated together for any one step, all the financial assets should add up to $0 equity (as long as no coins are involved). But the reality is I was just lazy and so I cut and pasted from Example 8. ;^)

5 comments:

  1. Thanks, Tom. Much appreciated!

    LindaG

    ReplyDelete
  2. Tom,

    Can you clarify what the CB loan on reserves mean? Perhaps I'm not getting the illustration, but I thought when a person paid taxes - their balance sheet (bank account) would be debited for the amount of tax paid, these funds would flow via the central bank (meaning CB would receive a credit on the payee bank's account, the CB would debit that account and credit the receiving bank's account for the same amount. The beneficiary in this case is the Treasury.

    Other than being a clearing mechanism - the CB plays no other role and this movement should not impact the CB's balance sheet, since it's the same banks that fund their accounts at the CB.

    Am I misunderstanding your illustration here?

    ReplyDelete
    Replies
    1. Vanessa A, I'm not sure I follow your question completely. But let me try explaining a bit and see if that covers it. You'll note that in my contrived world, at step 2. above (the 1st step, since I'm borrowing the numbering from Example 8), that I've drawn a single empty balance sheet (no assets and no liabilities) for both the CB and the Tsy (I just labeled the one BS "Tsy, CB"). You can take a look at Example 8 to see how we got to that point.

      Since we know paying taxes is going to result in funds in Tsy's Fed deposit account (the TGA), we know ahead of time that the CB's balance sheet has to expand to accommodate it... any assets in the TGA are necessarily simultaneously CB liabilities. My understanding is that the Tsy must spend from this TGA account. The Tsy also has what are called TT&L accounts at various commercial banks, but these are more like holding accounts: prior to any spending, the Tsy must request the commercial banks holding those TT&L accounts to transfer their funds to Tsy's TGA. Presumably the taxing process would result in the tax payer's bank account balance being transferred by the commercial bank to the TT&L account this bank holds for Tsy.

      Since I'm starting off with the CB's balance sheet empty, that implies that the commercial bank (just one in this example) has no reserves, since reserve assets for Bank A must also simultaneously be CB liabilities.

      So in order for Bank A to transfer the TT&L account to Tsy's TGA, the CB must create reserves and then transfer that reserve balance to the TGA. But in order for that to happen the CB has to create the reserves in the 1st place. It could do it via an open market purchase of some asset (for example the house: pretend for a moment that the Fed is allowed to buy houses) or it could loan the reserves into existence. I've chosen to show that it loaned them into existence. This lending may be called a "repo" or a "reverse repo" (I get them confused), but that's essentially what it is.

      Does that help?

      Keep in mind that I normally skip all the details involving the TT&L accounts because I don't think it's that important in the grand scheme of things: I just show the end result.

      You can see the nitty gritty details using the "macro balance sheet visualizer" at econviz.org (they have TT&L operations in the pull down list of commands you can try out).

      I hope that helped!

      Delete
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