Sunday, March 30, 2014

Money Myth 1: The purpose of taxes is to raise funds for government spending.

Fact: 100% of government spending is done through the creation of new money. Taxes cannot fund the spending of sovereign governments - they simply remove some of the money that was already spent. 

As currency-issuers, sovereign governments are very unique. They are not at all like households or businesses and should NEVER seek to "balance their budget" (i.e. tax back all the money that they issue into the economy each year), because they have a solemn responsibility, as the monopoly issuer of the nation's money, to balance the economy to maintain full employment. Without the government being responsible in this role, the economy suffers greatly, as we have seen these past few years.  

For any sovereign currency-issuing nation, the national government has been given the exclusive power by the people to issue the nation's money units, with the intent that such issuance should be used for public purpose; i.e. for the good of the nation, its people, the environment, and the economy. The people, through their representatives in government, can use that sovereign money for their collective needs (paying soldiers/teachers/judges, building national infrastructure, preserving national parks, etc.) 

The power to issue money is just that - issuing new money (not taking from others)! Issuing government money must precede any subsequent collection of that money back (taxes). The government can't collect back (tax) what is not yet given to the people via the process of spending/investing that money into the economy. And since we all like to save, it is usually best that the government leaves some of the money it issues in the economy. We usually call this a "deficit" but it is really just new money that has been injected into the economy and not yet taxed back out, to compensate for our national savings desires. See here for more about why our level of saving is linked to the need for government "deficits".

Now it is easy to see how we became confused into thinking that governments have to tax in order to spend. Partly, this is because it is actually true for all state, county and city governments or those nations which have given up their sovereignty by using another currency (e.g. the Euro). All of these governments really do have to operate like a household or business, only spending to the level of their tax receipts plus any approved borrowing. It just isn't so for the national government. 

Part of our confusion also arises from the fact that for a period of history, all nations gave up the sovereign control over their national currencies by agreeing to a system of fixed exchange rates and promising to convert their currency to gold (which of course they could not create on demand when they needed to). This system ended in 1971 for good reasons when the US stopped promising to convert the US Dollar to gold. However, we still tend to think of our national money as though we still had those constraints in place. We don't. We are free to issue our own currency for our national interests and the prosperity and well-being of our people - as should all nations! 

We need a new way to think about sovereign money. It is an incredibly powerful invention and has great benefit for the good of people if used wisely. But we can;t use it wisely when we don't know how it works. "Balancing budgets" and "raising taxes" to "pay for" spending is a damaging and destructive approach to responsible government and can never lead to a healthy economy.   

For any nation that issues its own currency and has a floating exchange rate, spending by the government must precede taxation, not the other way around. If State money (e.g. US Dollars) comes from the US government, how can the government first ask citizens to give it money before it can spend? We need to obtain government-issued currency first before we can return it to the government in payment for any taxes owed. 

The sequence matters immensely. We simply are not constrained in the way we have been taught. We are like slaves to the gold standard that still imagine we wear its shackles even though they have been gone for over 40 years. 

  • We don't need to raise taxes every time we have a new task we need the government to fund. 
  • We don't need to cut one government program in order to free up money for a new one. 

Sovereign money such as the US Dollar is like the government's IOU which we can return to the government in payment for our taxes. When taxes are paid, the IOU is extinguished. That money is essentially gone - eliminated. It gets taken off the books. If the government needs to spend, it just creates more money. It makes no sense for the government to save our tax money (i.e. IOUs we have redeemed) since it can always just credit bank accounts with new money. Taxes serve no funding purpose for sovereign governments. Zero!

So why tax at all? Simply this: taxes create the universal demand within a nation for the State money that the government issues. By granting the government the power to tax us, we are granting it the ability to issue a money unit as a way to provision resources. That money will be universally accepted throughout the nation since we now all need to obtain that money in order to pay our taxes. 

That's what makes a national currency work! 

Taxes actually serve three main purposes:

  1. As we just stated, the most important purpose is to create adequate demand for the government-issued money. Without taxation no one would accept the government "fiat" money in payment for anything. With taxes, we all accept it.  
  2. Secondly, taxes help to regulate the economy overall, which is mostly about managing to full employment and keeping inflation in check. 
    • Taxation should be increased (removing money from the economy) when too much government money has been added relative to the productive capacity of the economy leading to too much money seeking too few goods (this is a relatively rare form of inflation caused by excess money; most inflation is actually caused by commodity cost increases). 
    • Taxation should be reduced when there's not enough money in the economy to buy all the productive output of the nation or when the private sector increases savings (which means they aren't buying goods & services). This usually shows up as unemployment, and it is the fiscally responsible role for the currency-issuer (and its moral obligation for human dignity) to maintain balance in the economy to sustain full employment. 
  3. To discourage or encourage behavior for the common good. Taxation can be an important tool to direct resources for the good of the people or the environment that are otherwise being poorly distributed by the forces of capitalism.

So next time someone complains about some "taxpayer funded" federal government program they don't like, you can inform them that taxes don't fund anything! Sure, we should seek a more efficient and responsible government. But we should never seek to force our government to take back (tax) all the money it creates (spends) or we will be unable to collectively save and we will keep our economy well below full employment and full productivity. And who wants that?!

More Reading

For those who want to dive into the technical stuff right away, read economist Stephanie Kelton's paper Can Taxes And Bonds Finance Government Spending?

Also, check out these posts:

Where does money come from?

Taxation for Dummies