Seigniorage is the income that the government gets by printing money. It costs the government a few cents to print a $20 bill, and they get to spend it to purchase $20 of goods and services. Of course, printing money causes inflation. If the government tries to get too much income from seigniorage, the result is hyperinflation.
However, if the economy is growing, as modern economies typically do, then you need to keep expanding the money supply or there will be deflation. If the population is growing by 2% an year and real per-capita incomes are growing by 2% a year, then the government must increase the money supply by 4% a year to get an inflation rate of zero. There is 4% more actual stuff being produced each year, so in order for money to be worth the same, we need 4% more money. Increasing the money supply by 6% a year would produce an inflation rate of 2% a year, which is about the right amount.
Fractional Reserve Banking is the banking system used in all countries in the modern world. Put bluntly, it means pretending that loans are money. Most of the money in your checking account and savings account is not backed up with actual cash. Your bank probably has cash reserves that are less than 10% of the value of its depositors' checking and savings accounts. The rest of your money was used to make loans to people. You get to treat your bank accounts like money, but it is not money the government printed. It is money that the bank made up by loaning your money out to people and then telling you that you still have the money.
This system is just as unstable and volatile as it sounds. Many of the economic crises in history have been caused or worsened by the failures of banks using this system. Even when banks do not fail, the economy is harmed by the fluctuations in the money supply that result from changes in the percentage of money kept in reserve by banks.
It would be possible to change the laws so that retail banks that deal with consumers would be forced to keep full reserves. This wound inevitably mean that you would never get any interest on your bank accounts, and would in fact have to pay the bank a fee for storing money and processing transactions. If you wanted to earn interest, you would have to withdraw your money and go to a different company that handled loans.
People have proposed this as a way to escape the economic volatility of our current banking system. This would be a big and difficult change, and I do not know if it would be worth the cost. A big problem for these proposals is that the creation of 'credit money' is not limited to the retail banking system. There is a 'shadow' banking system used by large corporations and financial institutions that also converts loans into assets and trades those assets like money. The recent financial crisis featured a run on this shadow banking system, which caused a fall in the money supply.
Everything I have said so far is basic monetary economics. Now I will combine the facts about Seigniorage and Fractional Reserve Banking and point out something that I have never seen anyone discuss.
Fractional Reserve Banking means that the money supply increases by much more than $1 for every dollar the government prints. If the government increased the supply of currency by 1% a year, then we could have inflation of as much as 10%. Every dollar the government prints is transformed by the banking system into a lot more dollars.
This means that almost all of the seigniorage in modern economies goes directly to financial institutions. The money supply of the USA increases by about 5% a year, which means that somebody is getting seigniorage income equal to 5% of the money supply each year. The government is only getting a fraction of this. All of the rest goes to banks. Given that the money supply (M2) is around 9 billion dollars, that is over $400 billion every year going to the banks
Some of this subsidy will be passed along to consumers in the form of lower prices for banking services, to the extent that banking is a competitive industry. However, the total profits of the financial industry have between around $350 billion on average for the past 10 years. If the industry was competitive, that number would be a lot smaller. A lot of people who study the issue say that banks are making abnormally large profits.
It is probably a coincidence that financial industry profits are close to the annual amount of seigniorage captured by the financial sector, but it seems clear to me that banks are getting vast quantities of free money on a regular basis. It is not technically a subsidy, but the facts of fractional reserve banking and the money multiplier mean that almost all of the 'inflation tax' must be going straight to them.
If fractional reserve banking were eliminated, you could support all of the operations of a modern state with nothing but seigniorage. Most of the budgets of the USA and other developed countries go to transfer payments like Medicare, Medicaid, Social Security, and other entitlement spending. Operations costs are typically 5-10% of GDP. The USA could support all of its discretionary and military spending with no federal taxes at all, if it could capture all of the seigniorage from an increase in the money supply of about 15% a year. That is very high, and would distort the economy, but the current system of taxation also causes a lot of distortions.
Cutting our military spending to pre-9/11 levels and trimming some of the obvious fat from government would take the required money supply growth down to about 10%, which would give an inflation rate of about 7%. That is still high, but I would definitely take 7% inflation in exchange for no federal taxes.
Huge changes like this are nothing but fantasy thought experiments, of course. But it is possible to imagine a world where all of the operations of all levels of government can be supported with only seigniorage and taxes on externalities like pollution. With proper economic policy, the taxation of productive activity could be swept into the dustbin of history.