Mack Ott

Money and Taxes: The Relation Between Financial Sector Development and Taxation

Requiring taxes to be paid in domestic money provides a legal tender basis for money demand and hence to the development of a financial system. In emerging markets, the level of taxation is a positive factor boosting financial development. At higher tax rates, however, taxation provides an incentive to reduce money demand and reduces the size of the financial sector. There is also evidence of re-switching in high-tax developed countries, where financial deepening increases with the tax rate. Such financial deepening represents a form of capital market repression, not unlike the growth-depressing effects of financial repression in many poor countries.

Government Finance and the Demand for Money—The Relation between Taxation and the Acceptability of Fiat Money

Requiring taxes to be paid in domestic money provides a valuable characteristic for a states money. In the case of a states fiat money, it is the foundation for money demand and hence to the development of a financial system built around state money. Except for relatively highly taxed countries, where taxes may encourage tax avoidance and holding bank deposits, the level of taxation is a positive factor boosting financial development. Granger causality tests for 65 countries over the past half‐century examine the relationship between money and government finance. Except for the low‐income countries, where there are only five with adequate data, the causal relationship between taxation and money demand is generally supported in the 60 countries making up the three higher income groups.