Taxes and Praxis

Taxpayers’ Money. If you want to fill a room with indignation and entitlement, fewer phrases do it faster. Whether it’s a news anchor asking how the federal government is going to bankroll its promises, or a disaffected citizen admitting that yes, he’s the one who’s been paying for all of those politicians’ salaries this whole time, Taxpayers’ Money is always and everywhere being misappropriated, mismanaged and misspent. But in most cases, Taxpayers’ Money isn’t doing any of these things. In this post, I hope to reassure you that if you want to stay angry about taxes, you can, but you should make sure it’s for the right reasons.

The finger thing means the taxes!

From the outset, I should clarify that we’re talking about the kinds of taxes levied by a sovereign government: one which issues a unique, identifiable and non-convertible currency through its central bank (as is the case in Australia, Canada, Japan, New Zealand, the United Kingdom, and the United States, among others). We’re not talking about taxes levied by these countries’ state governments and city councils, nor those levied by the eurozone nations. These governments are all effectively using a foreign currency when they tax and spend; for example, there’s no longer a Greek Drachma (at least for now), nor is there a Western Australian Dollar (at least for now). So let’s keep it federal, let’s keep it sovereign.

The Bottom Lines

In case either of us gets buried in balance sheets before the end, here are the bottom lines.

  • Taxes are part of the ‘final finance’ (or funding) rather than the ‘initial finance’ of government expenditure. In other words, if the Australian Government wants to buy something, it doesn’t need your money first. Your taxes can’t be cited as ‘paying for’ specific government spending initiatives, even if the ATO might want to slice it that way. Taxes are simply the price you pay for representation.
  • While taxes aren’t needed for initial finance, they serve at least four (worthy) purposes:
    1. To ‘drive’ demand for the government’s coin (a sufficient, but not necessary condition)
    2. To penalise industries or individuals to the extent that they produce or consume ‘bads’ rather than goods
    3. To curb private sector spending and contain inflationary pressure
    4. To align the distribution of income with the public purpose.

The finger thing means the taxes!

How the federal government spends

This might get a little abstract, so let’s start with a concrete example. Recently, the Department of Immigration and Border Protection commissioned a Sydney film-maker to produce Stop the Boats: The Feel-Good Movie Event of the Year, at a budget of $4 million. (Adjusted for inflation, this is about five times the budget of The Castle.) The reason you didn’t see Peter Dutton pop up in Question Time to plug the Kickstarter–other than the likely aesthetic and anaesthetic consequences–is because he didn’t bother launching one. He didn’t need your money.

Aspiring governments ask for your broad endorsement of their proposed expenditures at election time. If you’ve elected them to represent you, they take this as consent to tax you. When the time comes to spend, the successful government takes your taxes as a sign that you approve of its general plans. But it needn’t take your taxes to pay for anything.

So how would the Australian Government have paid for this film? If we assume that the full $4 mil was fronted by the Department of Immigration and Border Protection, then operationally speaking, it would’ve happened a little something like this.

Down among the reeds and rushes, there was no comment in relation to on-water matters.

The ‘cold dead hand’ thing means the taxes!

STOP THE BOATS
A Screenplay
by
Hon Peter Dutton MP
Minister for Immigration and Border Protection

Cast of Characters

Peter: A government minister, reminiscent of young Brando.

Glenn: Peter’s taciturn central banker.

Joe: Peter’s cherubic sidekick and national treasure(r).

Trudi-Ann: Film-maker and conscience voter.

Gail: Trudi-Ann’s bank manager.

Boat People (unseen): ensemble of ca. 24 million, arrived and unarrived, yearning to be free.

ACT I

Scene 1: Peter issues bonds in the secondary market

PETER offers $4 million in securities (government bonds) to GAIL’s bank. The bank decides to buy these bonds.

The bonds are an asset to GAIL. In buying bonds, GAIL’s bank didn’t use any of its depositors’ money. It merely wrote up the new asset and liability in its ledger, in the same way it does whenever it creates a loan. Everything is done ‘on paper’, rather than ‘on polymer’ (currency).

The bonds are a liability to PETER, but in selling them he’s received a deposit, which one day might finance his movie, and which he could withdraw from GAIL’s bank at any moment…

Government Sector Private Sector
Peter (& Joe) Glenn Trudi-Ann Gail
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
I-1 Deposit +4 Bonds +4         Bonds +4 Deposit +4

Scene 2: Peter switches banks

PETER exercises this option, transferring his $4 million deposit to GLENN’s bank. It just feels safer there.

As a result, GAIL’s bank is bereft of its $4 million deposit. This translates to a $4 million shortfall in its exchange settlement (reserve) account, which is held at GLENN’s bank.

GAIL’s bank is in overdraft with GLENN’s bank. If more depositors emerge wanting to withdraw their funds, GAIL could be in serious trouble.

Government Sector Private Sector
Peter (& Joe) Glenn Trudi-Ann Gail
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
I-1 Deposit +4 Bonds +4         Bonds +4 Deposit +4
I-2 Deposit +4 Bonds +4 Deposit +4
Reserves -4
Bonds +4
Reserves -4
Deposit 0

Scene 3: Glenn saves the day (the first time)

GLENN senses a $4 million shortfall in reserves. GAIL still has $4 million in bonds, but would prefer to use them to pay off her overdraft with GLENN.

GLENN offers to buy the bonds from GAIL’s bank. GAIL, relieved, relinquishes her bonds and restores her overdraft. GLENN now holds $4 million in government bonds.

GLENN also retains custody of PETER’s $4 million deposit, which Peter could withdraw at any time…

Government Sector Private Sector
Peter (& Joe) Glenn Trudi-Ann Gail
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
I-1 Deposit +4 Bonds +4         Bonds +4 Deposit +4
I-2 Deposit +4 Bonds +4   Deposit +4
Reserves -4
    Bonds +4
Reserves -4
Deposit 0
I-3 Deposit +4 Bonds +4 Bonds +4 Deposit +4
Reserves 0
Bonds 0
Reserves 0
Deposit 0

ACT II

Scene 1: Peter makes a movie

After re-watching Kevin Costner’s Waterworld, PETER gets the urge to make a big-budget, high-grossing maritime movie.

PETER withdraws his $4 million deposit from GLENN’s bank and pays TRUDI-ANN to realise his artistic vision. By creating a negative net worth for himself (a deficit), PETER creates a positive net worth for TRUDI-ANN (a surplus).

TRUDI-ANN banks with GAIL, who receives her $4 million deposit as a liability. But the deposit also boosts GAIL’s reserve account by the identical amount, which GLENN duly notes.

Government Sector Private Sector
Peter (& Joe) Glenn Trudi-Ann Gail
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
I-1 Deposit +4 Bonds +4         Bonds +4 Deposit +4
I-2 Deposit +4 Bonds +4   Deposit +4
Reserves -4
    Bonds +4
Reserves -4
Deposit 0
I-3 Deposit +4 Bonds +4 Bonds +4 Deposit +4
Reserves 0
    Bonds 0
Reserves 0
 
II-1 Deposit 0 Bonds +4
NW -4
Bonds +4 Deposit 0
Reserves +4
Deposit +4 NW +4 Bonds 0
Reserves +4
Deposit +4

Scene 2: The taxman cometh

By unwisely declaring her company’s operations in Australia rather than offshore, TRUDI-ANN consents to being taxed.

Using one of the highest company tax rates in the world, JOE reduces TRUDI-ANN’s income, taking about $1 million. TRUDI-ANN pays her tax by asking her banker, GAIL, to transfer her money to JOE’s account. TRUDI-ANN’s deposit balance falls to $3 million, prompting an equal fall in GAIL’s reserve balance.

JOE (who has a joint account with PETER) deposits this tax revenue in GLENN’s bank.

GLENN has seen two changes in his balance sheet this scene: GAIL’s reserve balance has fallen to $3 million, and PETER & JOE’s account has added $1 million.

Government Sector Private Sector
Peter (& Joe) Glenn Trudi-Ann Gail
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
I-1 Deposit +4 Bonds +4         Bonds +4 Deposit +4
I-2 Deposit +4 Bonds +4   Deposit +4
Reserves -4
    Bonds +4
Reserves -4
Deposit 0
I-3 Deposit +4 Bonds +4 Bonds +4 Deposit +4
Reserves 0
    Bonds 0
Reserves 0
 
II-1 Deposit 0 Bonds +4
NW -4
Bonds +4 Deposit 0
Reserves +4
Deposit +4 NW +4 Bonds 0
Reserves +4
Deposit +4
II-2 Deposit +1 Bonds +4
NW -3
Bonds +4 Deposit +1
Reserves +3
Deposit +3 NW +3 Bonds 0
Reserves +3
Deposit +3

Scene 3: Glenn saves the day (the second time)

Something’s wrong. GLENN senses a $3 million imbalance in the reserve system. PETER’s movie exploit has led to an excess of reserves at GAIL’s bank which, unless drained immediately, threatens to push the cash rate down.

GLENN remembers the bonds he bought in ACT I Scene 3 and offers them to TRUDI-ANN. The bonds, GLENN argues, can earn TRUDI-ANN a higher rate of interest than her deposit does. TRUDI-ANN takes the deal, which alters the asset side of her balance sheet, and prevents the cash rate from deviating from GLENN’s target.

TRUDI-ANN might want to sell her bonds and withdraw cash, or otherwise thicken the plot, but those are stories for another day.

Government Sector Private Sector
Peter (& Joe) Glenn Trudi-Ann Gail
Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities
I-1 Deposit +4 Bonds +4         Bonds +4 Deposit +4
I-2 Deposit +4 Bonds +4   Deposit +4
Reserves -4
    Bonds +4
Reserves -4
Deposit 0
I-3 Deposit +4 Bonds +4 Bonds +4 Deposit +4
Reserves 0
    Bonds 0
Reserves 0
 
II-1 Deposit 0 Bonds +4
NW -4
Bonds +4 Deposit 0
Reserves +4
Deposit +4 NW +4 Bonds 0
Reserves +4
Deposit +4
II-2 Deposit +1 Bonds +4
NW -3
Bonds +4 Deposit +1
Reserves +3
Deposit +3 NW +3 Bonds 0
Reserves +3
Deposit +3
II-3 Deposit +1 Bonds +4
NW -3
Bonds +1 Deposit +1
Reserves 0
Bonds +3 NW +3 Bonds 0
Reserves 0
Reserves 0

Fin.

What just happened?

The most exciting rendition of deficit spending you’re ever likely to see, that’s what! Despite the theatrics, I hope it represents, without much controversy, a day in the life of a central bank managing the government’s accounts. What were the important plot points? More importantly, where did your tax dollars go?

Have you looked under the ATM?

Have you looked under the ATM?

Firstly, some critics argue that ACT I could be abolished altogether. Indeed, Peter’s selling bonds to and then buying them back from Gail’s bank does appear to be indulgent padding. Couldn’t Peter have sold bonds to Glenn directly and started this whole tableau from ACT II? Not under current arrangements. In Australia, the central bank (Glenn) prefers to avoid entering the primary market, because it would violate the principle of ‘central bank independence’. So Peter has to sell bonds to Gail’s bank first, even though the result would have been the same had he gone to Glenn’s.

Secondly, regardless of who buys Peter’s bonds, the central bank must add or drain reserves if it wants to hit its cash rate target. If Glenn hadn’t saved the day in ACT I Scene 3, Gail would have looked (off stage) to other banks to replenish her reserves. Because there simply wouldn’t have been enough reserves to satisfy all banks at the prevailing cash rate, Gail’s excess demand would have threatened to push up the cash rate. Similarly, in ACT II Scene 3, Glenn had to save the day again, by draining the excess supply of reserves from Gail’s account, which otherwise threatened to drive the cash rate down.

Thirdly, the government deficit is equivalent, by definition, to the private sector surplus. Every dollar Peter spent, minus the dollars Joe took back, ended up in Trudi-Ann’s hands. So if you’re inclined to argue for a smaller government deficit (less expenditure or higher taxes), you’re also arguing for a smaller private sector surplus (less disposable income for Trudi-Ann). Sometimes, a smaller deficit might be entirely appropriate (see the four reasons cited at the start of this blog!) But regardless of your rationale, you’ll be reducing Trudi-Ann’s income too. And if you want to run a government surplus, Trudi-Ann will have to run down her savings, or sell her business, or take on a bank loan to make the tax payments demanded by her supposedly representative government.

Finally, crucially, taxes didn’t appear until very late in the show. Peter had already spent government money before Joe realised he could take some back. But Peter wasn’t constrained from the outset. Taxes didn’t finance anything.

So get angry about Taxpayers Money, if you feel that’s productive. But do it because you feel that the government is penalising the wrong people, or if a cut in your taxes wouldn’t lead you to overspend to the point of inflation, or if you think that the whole schedule of taxes is out of order. If taxation is representation, and your representative government isn’t fulfilling that mandate, then that should be the source of your ire. Because your taxes are a source of your consent, and needn’t be a source of funds.

Recommended reading

The following sources explain the mechanics of this process with varying degrees of clarity. This post draws particularly from Lavoie (2013); Mosler (1995); and the various Reserve Bank of Australia publications. If, after the previous 2000 words, you want some more, click through!

  1. Australian Office of Financial Management (2015), ‘Securities Lending Facility‘, Australian Government, http://aofm.gov.au/ags/securities-facility/
  2. Baker, A. and Jacobs, D. (2010), ‘Domestic Market Operations and Liquidity Forecasting‘, RBA Bulletin, December, pp 37–44.
  3. Bell, S. (2000), ‘Do Taxes and Bonds Finance Government Spending?‘, Journal of Economic Issues, 34(3), pp 603–620.
  4. Fullwiler, S.T. (2008), ‘Modern Central Bank Operations–The General Principles‘, Center for Full Employment and Price Stability Working Paper, June.
  5. Fullwiler, S. T. (2012), ‘Krugman’s Flashing Neon Sign‘, http://www.nakedcapitalism.com/2012/04/scott-fullwiler-krugmans-flashing-neon-sign.html.
  6. Godley, W. and Lavoie, M. (2007), ‘Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth‘, Palgrave Macmillan: Hampshire.
  7. Juniper, J., Sharpe, T. and Watts, M. (2014), ‘Modern Monetary Theory: Contributions and Critics‘, Journal of Post Keynesian Economics, 37(2), pp 281–307.
  8. Lavoie, M. (2013), ‘The Monetary and Fiscal Nexus of Neo-Chartalism: A Friendly Critical Look‘, Journal of Economic Issues, 47(1), pp 1–32.
  9. Mitchell, W. F. (2010), ‘Taxpayers Do Not Fund Anything!‘, http://bilbo.economicoutlook.net/blog/?p=9281
  10. Mosler, W. B. (1995), ‘Soft Currency Economics‘, http://moslereconomics.com/mandatory-readings/soft-currency-economics/
  11. Newman, F. N. (2013). ‘Freedom from National Debt‘, Two Harbors Press: Minneapolis.
  12. Reserve Bank of Australia (2015) ‘Domestic Market Operations‘, http://www.rba.gov.au/mkt-operations/dom-mkt-oper.html
  13. Reserve Bank of Australia (2015) ‘Open Market Operations‘, http://www.rba.gov.au/mkt-operations/resources/tech-notes/open-market-operations.html
  14. Tymoigne, E. and Wray, L. R. (2013), ‘Modern Money Theory 101: A Reply to Critics‘, Levy Economics Institute of Bard College Working Paper No. 778.
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  1. Taxes and Praxis: Technical Notes | Pamphlets into the Wind
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