Do tax revenues finance government spending?

The Economist had a piece  on Britain’s tax base in its 25th January edition. It begins with a reference to Denis Healey’s speech to the 1973 Labour conference, in which he promised that tax increases  would be met with “howls of anguish” from everyone, not just the rich. As it happens, I have been reviewing the record of Labour Chancellors this last week. With the exception of Hugh Dalton, they were all financially orthodox, and almost all resorted to raising taxes and cutting government spending. In other words, they believed that government budgets were like household budgets, and government expenditure could only be financed by raising taxes.  They felt it imperative to be remembered as “prudent” Chancellors, committed to “balancing the government’s books”. – above all else.  None of them succeeded of course, because Chancellors and their governments, no matter how powerful, popular or smart, cannot ‘balance the books’. Only the economy can. By which I mean that the balance of the government’s “books” is determined by the health and prosperity of the economy as a whole – including that of the private sector. If those Labour Chancellors had focussed on strengthening investment, productivity and employment – they would have raised more money from taxes, and would have had a much better chance of ‘balancing the government’s books’.

When the economy is powering along, when investment and employment and wages are high, when interest rates are low, and banks are supporting the real economy,  not just gambling on property price rises – then hey presto, the government’s books ‘balance’. When the economy is weak, when investment falls, and employment is low, or insecure, or low-paid; when private indebtedness and real rates of interest are high and the finance sector out of control – then government revenues from taxation will fall, and the government’s books will not balance.  If the government encourages workers to take up self-employment, insecure work on zero hour contracts – then invariably the government’s tax base narrows further. This is like sawing off the branch of a tree supporting the government. George Osborne as Chancellor in the 2010-2016 Coalition and Conservative governments, was skilled at sawing off the tax revenue ‘branch’ on which the Treasury was perched.

One big argument against raising taxes in today’s weak economic environment is that such a move will drain income (tax revenues) from an economy which is already weak –  constrained by high levels of private debt; by low productivity, low levels of investment and low incomes. (Wages have still not recovered to pre-crisis levels). While it will always be right to ensure that the rich pay taxes, and that HMRC is resourced to tackle tax avoidance, draining more income from the weakened economy – at this point in time – would not be wise. What the economy desperately needs is the injection of more finance and investment, not the extraction of income.

But perhaps the most flawed aspect of the Economist’s argument for “raising taxes” is this: governments do not finance their investments, or even their activity, from tax revenues. Most of the government’s big expenditures are financed via the issuance of gilts – government bonds. The sale of gilts provides the government with finance for investment and expenditure. (And at the same time gilts provide a safe haven for pension funds to invest savings deposited with them. In due course  (when we retire) those pension funds return the gains from investing in gilts to us, the UK’s pensioners, savers and taxpayers.)

It is public investment and expenditure, coupled with private investment and expenditure, that generates government income. This is because government investment and expenditure creates and pays for jobs. And those in employment both pay taxes, but also trigger more tax revenues when they spend on housing, food and other goods and services. And if that spending generates profits, and shopkeepers and companies pay corporation tax, then government benefits from yet another revenue stream.

When the private sector is too timid or greedy to invest to create jobs that generate tax revenues , that is when a government – backed by a central bank – ought to use its heft to raise finance and invest to create employment and thereby generate income in the form of tax revenues.

Of course it is really important that government should repay its borrowing. And that is where tax revenues come in – after the investment, taxes provide the income needed to pay back the government’s debts, and  ‘balance the books’.

But taxes are not the source of government financing, and are not necessary for government to spend. 

When the economy is weak – when the private sector is weak – then squeezing citizens dry by raising taxes, is very bad economics. The best strategy for the government in those circumstances is to invest to expand employment.

Expanded employment – especially in skilled, well-paid, productive work – will generate more tax revenues for the government, without tax hikes. And public investment will benefit the private sector – both directly and indirectly.

Its not rocket science!

 

 

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7 thoughts on “Do tax revenues finance government spending?”

  1. Well, Anne. This article started off all well and good until it got to “Most of the government’s big expenditures are financed via the issuance of gilts.”

    No they aren’t. In a country, like ours, that issues its own currency, they are financed by the government instructing its Central Bank to credit the reserve account of the commercial bank at which the target of the spending holds a current account. That’s it. A currency-issuing government does just what it says on that tin – it doesn’t need to get the currency from anywhere. All it needs to do is to ensure that it is not issuing more currency than there are real resources on sale.

    It might be government policy to issue Treasury paper to match it’s excess of expenditure over tax revenues, for example as a rule of tumb, but that is just a choice. Or, in our unfortunate case, a requirement of our having signed up to the Lisbon Treaty. Only a hard Brexit will prevent that; even then I’m pretty sure we will finish up with some sort of trade agreement that involves our adhering to all those rules. Otherwise we would have an unfair advantage over the rEU, and they know it.

  2. I admire your work and own your book (The Production of Money), but as a follower of Modern Monetary Theory, I have to disagree with your belief that government spending is ‘financed’ by the selling of government bonds.
    Surely the money that government gets from the private sector in exchange for these bonds was originally issued by government itself – if not, then by who? Money created by private banks in the form of loans has to be paid back to the bank, unlike money created by the government central bank, spending into the private sector. It follows then, that all long-term savings (such as those held by e.g. pension funds) must be government money.
    The alternative is that government spending is ‘financed’ by private banking loans – is this what you believe?
    I agree that taxing incomes is a drag on the economy, but he belief that the government needs some ‘revenue stream’ such as taxes to ‘pay back the governments debts’ is frankly quite wrong. You must know that government bonds aren’t debts in the normal sense of the word.
    I fear that the ‘rocket science’ you refer to needs some updating. Chinese fireworks vs, SpaceX rocket?

      1. Thanks for the link, Anne. However, Andrea Terzi doesn’t appear to mention anything to validate the belief that government spending is financed by borrowing (which is no surprise from a member of the MMT community), rather the paper is more concerned to show that all savings is ‘debt” of one kind or another. Savings, of course, like taxes, are a drain on the productive economy.

        I prefer Andrea’s exposition of the basics of MMT in the following dubiously-titled MMT blog:
        https://money4nothingchicks4free.wordpress.com/2012/02/26/civilized-money-view-vs-monetarist-keynesianism/

        As an aside – Jeez, that’s one scary photo of you in your Wikipedia entry- time for an edit, I think!

        1. Brian….Is MMT a religion? Are we all obliged to prostrate ourselves before your superior wisdom, and confess apostasy? The key point about Andrea Terzi’s paper is that it explains that all money – including central bank ‘money’ – is both an asset and a liability. That there is no asset (‘helicopter money’) without a liability. That liability can be a bank’s ‘promise to pay’ backed by collateral; or a government’s ‘promise to pay’ issued via a bond or Treasury bill – and backed by the government’s collateral (tax revenues). In other words, the government incurs a liability by borrowing the resources from the CB (which in the case of the BoE is a nationalised, i.e. govt bank)…and promising to repay, at what could be a negative rate, over a fixed period, or indeterminate period (perpetual)..I consider this relationship between borrower and lender to be vital for the transparency of the transaction – having worked in African countries where there is virtually no transparency between the CB and the government…The asset – ‘helicopter money’ – cannot be created without a liability issued. And millions of individual taxpayers cannot be expected to issue a liability, and a’promise to pay’ in order to draw down a share of the asset that is ‘helicopter money’.
          That is my point.

    1. Thank you Brian…Similarly, Can I recommend you read Andrea Terzi…the link is in the comment above…He, as I understand it is a member of the MMT community. Its not easy, but then this subject is not easy…

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