Author:Lastrapes, William D.

Government-issued paper currency is under fire. Proposals to eliminate it--or at least to demonetize and no longer issue large denomination notes--are prevalent (Rogoff 1998, 2016; Sands 2016). Proponents point out that paper notes--circulating bearer-bonds that pay a zero (nominal) return--promote underground and illicit economic activity because of their anonymity, and preclude "negative interest rate" monetary policy during financial crises and severe downturns. Taking currency out of peoples' hands will increase the costs of bad behavior, and free up the Fed. (1)

Clearly, doing away with paper currency entails important tradeoffs that must be considered by policymakers. Whereas currency might reduce the costs of tax evasion, corruption, and ding trafficking, and cause discomfort to central bankers, it has a long history as a beneficial and popular means of legitimate payment. Whether we should support proposals to eliminate large-denomination banknotes or circulating currency altogether depends on whether, overall, die benefits of doing so exceed the costs. Does ditching currency improve social welfare?

I argue that there are two essential dimensions to any approach that seeks an answer to this question. First, the framework for analysis must he one of general equilibrium--all channels through which such a major policy change affects economic incentives and behavior, both direct and indirect, must be considered. Second, the analysis must be quantitative. Pointing out the potential responses to the policy change can give us an understanding of the qualitative nature of the effects of demonetization, but only gets us so far. Understanding their overall effect on human well-being requires assessing the magnitudes of the tradeoffs, how big the costs and benefits are. Formal models of the overall economy are needed to achieve this understanding.

The aim of this article is to make an initial pass at measuring the welfare effects of currency elimination in the United States using the tools of macroeconomic theory. I rely on a standard dynamic general equilibrium model extended to allow households to avoid taxes by not reporting income, where holding and using money helps toward that end. Money in the model also serves to reduce the costs of legal transactions in consumer goods. Thus, the model, in a stylized but general way, captures the demand for holding money both for legitimate purposes and to facilitate tax evasion. For tractability, my model does not distinguish currency from other forms of transactions media; the model's analog to currency demonetization is the analytical assumption that government monetary authorities can control how productive money is as a tax evasion device. In the model, reducing the productivity of money for tax evasion is tantamount to lowering the share of paper money in the nation's overall money supply. I use this framework to illustrate the basic macroeconomic tradeoffs that eliminating currency would involve, and to quantitatively predict the overall effects on welfare. (2)

With only mild apologies, I set up the model to focus on tax evasion as die sole means by which paper currency can be abused, and ignore the many other illicit uses of cash, such as drug trafficking, prostitution, money laundering, and corruption. For many of these activities it would be straightforward to generalize the model to account for their role, but for my purposes doing so would excessively complicate things. Perhaps more importantly, though, tax evasion in the United States is, according to Rogoff (1998: 59), "truly massive" and is an important, if not the most important, underground use of cash in the United States. Thus, the costs and benefits of policies to diminish tax evasion--like currency demonetization--are relevant and worth studying. At the same time, while tax evasion introduces its own distortions and inequities, unreported income can also be an efficient response to tax distortions and can create incentives for work and production, which affects the cost-benefit calculus. It is also not clear how to appropriately incorporate some illicit activities, like the drug trade and prostitution, into the analysis when simply legalizing these activities would probably be

a first-best solution. Finally, the model in this article has nothing to say regarding the negative-interest-rate argument for eliminating cash; I simply note that there are many ways to pay negative interest rates on cash, as described by Kimball (2017) for example, so that the potential benefit of currency elimination has less importance for monetary policy than its supporters might suggest. (3)

Here is a rough sketch of the relevant interactions in the model. Holding currency, by encouraging tax evasion through unreported income, reduces the effective income tax rate of the average household. Thus, cash holdings increase after-tax returns to labor and capital, which in turn increase the supply of inputs to firms, increase output, and increase the tax base. Whether tax revenues rise with money and tax evasion depends on the relative strength of the opposing movements in the effective tax rate and the tax base. Government spends resources on public goods, which directly improves welfare and which also increases factor productivity (think of infrastructure expenditures, like roads). Government policy that reduces the effectiveness of money as a tool for tax evasion--like eliminating large-denomination notes--can therefore have complicated effects on welfare by affecting work (and leisure), production, consumption, tax revenues, and government spending. The model accounts for all of these effects and feedback loops. The model also accounts for the likelihood that policies to eliminate cash or large-denomination notes also unavoidably negatively affect the ability of money to reduce transactions costs for legitimate purposes.

There is a large literature on tax evasion; for surveys see Slemrod (2007) and Aim (2012). Balafoutas et al. (2015) is a recent attempt to measure the costs of tax evasion, while Mazhar and Mon (2017) empirically consider the impact of the underground economy and tax evasion for developing and developed economies. Gordon (1990) is an early theoretical effort to examine the role of currency for tax evasion but is not a general equilibrium analysis. Camera (2001) moves in the right direction with a search-theoretic, general equilibrium framework that specifically models interactions between illegal activities and alternative media of exchange. Yet his model is complex and there is no quantitative welfare analysis. Much work in this area uses currency demand to estimate the size of the underground economy, as in Cebula and Feige (2012). This work is useful, but none of these papers or those cited in the surveys provide direct estimates of welfare effects of currency demonetization, which motivates my paper.

Without question this model is too stylized and restrictive to provide confident policy advice. For example, not only do I ignore other factors besides tax evasion where the use of currency can impose costs to society, but I also do not account for other exchange media that can aid tax evasion. Yet the model remains a reasonable way to...

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