“… given (1) control of a central banking system and (2) an inconvertible currency, a sovereign national government is finally free of money worries and need no longer levy taxes for the purpose of providing itself with revenue. All taxation, therefore, should be regarded from the point of view of social and economic consequences.”Beardsley Ruml commenting on a speech by Chairman of the Federal Reserve Bank of New York, 1946.
Currency-sovereign governments, like the UK’s, pay public sector wages, fund new rail links, build power stations, fund welfare and so on. But where does the money to purchase those things come from?
Politicians and media commentators tell us that it comes from taxes. Taxes are collected and the government spends that money – until it’s all gone. At that point, ‘there’s no money left to fund nurses pay increases’. However, there’s a flaw in that understanding. That isn’t how currency-sovereign governments work. Taxes don’t pay for government spending.
So, what is the reality of it all?
In the UK, what happens in practice is that the government asks the Bank of England to spend whatever is required to fulfil their policy agenda. And, unlike the tax story told by politicians, the government can never run out of money. The UK government has a monopoly on the production of UK pounds and the Bank of England has a legal responsibility to respond to every government request. So, despite what you hear on your TV or read in our paper, lack of finance is never a barrier to government spending.
As fantastical as it sounds, currency-sovereign governments can spend as much money as they desire. That’s not to say there aren’t limits to how much they can spend. Clearly, they can only keep spending pound notes up to the point where there are no longer things to buy or people to employ. Beyond that, spending more can bid up prices i.e., it can lead to demand-lead inflation. I say ‘demand led’ inflation to contrast it with our current supply-lead inflation, i.e., the ever-increasing price of gas and other energy inputs.
A note for the sceptics
Are you sceptical about my ‘government can spend as much as it likes and never run out of money’ story? Here’s the Bank of England explaining how government funding works in practice. I’m not pulling your leg – that’s how it works. Them’s the facts.
Ponder this, the UK has run a deficit for most of the last 300 years. For example, since 1970, the average annual budget deficit has been 3.6% of GDP. A deficit is the difference between the amount of tax collected and the amount spent by government. All those yearly deficits when added up create the ‘government debt’ or sometimes called ‘The national debt’. In 2022, this amounted to £2,436.7 billion. Now, given that only a small amount of that is foreign debt, how do you think the government funds the difference?
How do currency-sovereign governments fund deficits?
I can tell you. The government ‘borrows’ the money [pause for effect] from itself. As I said earlier – the government just asks the Bank of England to spend money into the economy. If more is spent than is taken in taxes, it’s called borrowing. That ‘borrowing’ creates government ‘debt’. As Mr. Spock said, “It’s debt Jim, but not as we know it”. An economist will argue that the mechanism of money creation is much more complex than I am making out – however, the result is the same, i.e., whether the government sells interest bearing bonds or just marks up the government account – the results are the same, i.e., if it needs to or wants to, the government can spend more money into the economy than it collects in taxes. If it sells interest bearing bonds – the Bank of England creates the money to pay the interest.
If taxes are not used to fund spending, what are they for?
Now that we all agree that taxes don’t fund government spending, it makes sense to ask why you pay them and what they are for. I’ve made a list for you – so that despite this new knowledge, you will continue to pay your taxes. I don’t want you to go to jail for tax evasion because Jim told you that the government doesn’t need your tax money.
1. Taxes give the currency value
It is taxation that tells citizens what the legal tender of the country is – and what it is not. If you set up a printing press in your living room and print your own money – you can’t pay your taxes with those notes. And you can’t pay your UK taxes in US dollars, South African Rands or Chinese Renminbi – they may be legal for taxes in their own countries but not here. Only UK pounds are accepted. It is the fact that you have to pay taxes in UK pounds that gives the pound value. If someone pays you in UK pounds, you are happy to take those pounds and you are happy to exchange those pounds for goods and services. We don’t even think about it, we just understand that pound notes are the valid currency of the UK. And we know we need them to pay our taxes.
So, one important role of tax in a monetary sovereign country is to give value to the currency.
2. Taxes are used to shape government policy
In the UK when the electorate votes in a government, in theory at least, they are voting for the kind of society they want to live in, via the priorities of the party they vote for. Whatever government is voted into power, taxes are used to both control the economy and to shape policy. Governments of different hues will use tax policies in different ways.
3. Taxes are used to control inflation
Taxes are used to control inflation by reducing or increasing the amount of spending power in the non-government sector. Too much demand equals inflation and too little demand produces unemployment. If there is not enough spending power to purchase all goods and services, businesses will cut back. This will result in fewer goods and services, meaning fewer people are needed to make or provide those goods and services – which leads to increased unemployment.
So, governments can tax in a way that takes money out of the pockets of citizens and increase unemployment – or tax in a way that puts money into citizens’ pockets and increase employment. Overdoing the latter carries the risk of inflation if the country is already running at capacity.
Currency-sovereign governments control the amount of money circulating in the economy either by adding to it via deficit spending or reducing it by spending less than they bring in in taxes; that is called running a surplus. The risk associated with taking money out of the economy is the country going into recession. Even when a government runs a ‘balanced’ budget the amount of money circulating in the economy can go down, as citizens save or move a portion of their money abroad.
4. Taxes can be used to reduce or increase inequality
Taxation, once it is no longer thought of as a financial instrument, becomes, as Richard Murphy puts it, ‘an agent for change within the economy‘. For example, taxes can be used to redistribute income via progressive taxation policies. When a government increases taxes for those on high incomes and decreases taxes for those on lower incomes, those in the lower income bracket have more money to spend. So, if your policy goal is to try to reduce inequality, taxes are one lever you can use to achieve that goal. Equally, if your goal is to give more to those at the top of the income bracket – perhaps because you believe in the ‘trickle-down’ effect – you can also increase inequality. It is worth noting that currently the UK is the OECD country with the highest income inequality.
5. Taxes can be used to control what the market creates or doesn’t create
Governments can use tax to discourage or encourage the consumption and production of particular goods and services. For example, adding tax to the price of cigarettes may decrease tobacco consumption. This same tax strategy can be applied to any number of things, including tackling climate change. For example, by increasing tax on carbon producing activities such as burning fossil fuels for energy production.
Tax relief on the other hand can be used to encourage activities. It can provide incentives to build energy-efficient houses or insulate older properties or encourage the building of wind farms. It can be used to develop carbon capture technologies or encourage the development of green technologies.
When you understand that you can decouple taxes from the idea of it being a financial instrument, tax becomes an instrument for social change. That change can reflect our priorities as citizens via the governments we elect.
A note about Scotland
Much of what I have written above does not apply to Scotland. Scotland is not a currency issuer, i.e., Scotland does not have currency sovereignty and cannot create pounds to meet its policy needs. In contrast, Scotland has a fixed budget and limited tax-raising and borrowing powers. Unlike Westminster, Scotland can indeed run out of money – and it does have a fixed pile of money to draw upon. Therefore, it is important to note that my above explanation largely relates to independent countries with full currency sovereignty.