Tax Rascal

What’s Wrong With IOUs?

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What’s Wrong With IOUs?

The other day, California put its tax refunds on hold. Given their financial straits, that’s not such a bad idea — it was either that, or bouncing some checks, apparently.

But California isn’t the only one with bills to pay. What about people who were counting on a tax refund? There’s a big difference between $100 in hand and a $100 check that’s not in the mail now and won’t be for some time.

What’s odd is that usually, we have a simple way of dealing with this problem: California has made plenty of promises to pay billions of dollars in the future to fund spending it wants now — those promises are bonds. That’s simpler than just telling taxpayers to wait and see: if the state gave people state bonds of value equal to the amount they were owed, some people could wait for the state to pay, but others could sell their bonds and use the cash now.

Of course, the first objection is “What if everyone immediately sells their bonds, and the price drops too fast.” Unlikely: the state owes some $57 billion in debt, so the extra debt from tax refunds would be a drop in the bucket.

A more sensible objection is the transaction cost: for a $50 refund being paid as a bond due in three months, the cost of postage would be about as high as the cost of interest; adding up the costs of processing all of those new transactions indicates that the state would be spending a lot of money in order to avoid spending more money.

Of course, the whole point of this idea is that the state wants to avoid paying tax refunds now, even if they suffer some inconvenience for it. In the long run — or even in the very short run — it’s probably better for them to give taxpayers something rather than nothing. After all, if California’s lenders hear about what happens to people who California owes money, the result could be pretty unpleasant.


7 Responses to “What’s Wrong With IOUs?”

  1. Goose The Tax Dog Says:

    A third objection might go as follows: the reason that California cannot pay tax refunds in cash is that it is currently unable to borrow the necessary cash; that is, the state finds itself unable to entice anyone to lend it money on reasonable terms. Issuing bonds to taxpayers would be forcing those taxpayers into a bargain that nobody on the open market has been willing to enter. Thus, the value of the bonds would necessarily be less than the value of the refunds due the taxpayers. If I am a taxpayer owed $50, the state of California had better give me something worth something close to $50.

  2. admin Says:

    There’s no reason the state couldn’t give out bonds whose market value is equal to the value of the refund (or close enough; they could, for example, give away bonds in $50 increments, and pay the rest in cash). When California can’t borrow on ‘reasonable terms’, it means they need to pay a few percentage points more, not that they need to put everything on Arnie’s Capital One card.

  3. Goose The Tax Dog Says:

    If they could give out bonds whose market value is equal to the value of the refund, then why not raise the cash on the bond market as usual and then pay it out to taxpayers? Probably because the market would demand more percentage points than the state is willing to pay. Then why should we expect the taxpayers to accept a lower risk premium than bond market investors are willing to accept? Issuing a bond with $50 face value does not mean that the market value is $50.

    But I should have said earlier that your general point that IOUs aren’t such a bad thing probably has something to it. If the credit markets are out of whack, then promising to pay later with “reasonable” interest (as opposed to that being currently demanded by bond investors) seems to be a next-best-solution that most everyone can live with.

  4. admin Says:

    Those solutions would be equivalent (ignoring transaction costs). I guess the difference is that if they issue the bonds, California’s regular bond owners would get the message that the state needs to borrow a little more money. If they sent bonds to the taxpayers, it would instead get out the message that the state is in dire straits, which might lead taxpayers to change their behavior in useful ways.

    My point about the market price is that this would involve distributing something that does have the same market value — not face value — as the debt in question. It would clearly be a bad idea for California to pay people back X cents on the dollar by giving them debt instead of cash; much better to pay them off at 100 cents on the dollar by giving them debt that, at the market price, can be exchanged for the amount of cash the person would otherwise get. People who need the money can get it; people who don’t can help support their state’s finances.

  5. California is Nearly Bankrupt — And They’re Printing Money! | RapidTax Blog Says:

    […] ago, Taxrascal suggested that state IOUs aren’t so bad. Perhaps California’s treasurer read […]

  6. Does California Treasurer Bill Lockyer read Taxrascal? | Tax Rascal Says:

    […] tax blog is to be believed, California’s treasurer is doing exactly what this site suggested: paying the bills with IOUs! As predicted, these IOUs aren’t exactly like that time your brother-in-law promised […]

  7. Rosie Says:

    God help me, I put aside a whole afteronon to figure this out.

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