Taxes and Praxis: Technical Notes

In the previous post, Taxes and Praxis, I attempted to clarify a process which is constantly confused by mixed metaphors and misapprehension.

As far as I can tell, the balance sheet rendition of this process was accurate and watertight. (But of course I’d say that.) Nevertheless, the exposition did tread a tightrope strung between two positions on whether a sovereign government ‘needs’ tax revenue in order to spend. On one side are the so-called ‘neo-chartalists’ and on the other are the ‘horizontalists’. (To anticipate a T-shirt slogan, yes, some Economists Do It Horizontally.) From a sufficient height, these two arguments are so close as to be indistinguishable, because they’re making the same fundamental point. Certainly, taxes (or bond sales) appear to finance the spending of a sovereign government, under current institutional arrangements. For the government to spend, it has to have ‘money in the bank’ first. And the money in the government’s own bank account at any time is indeed the legacy of previous tax collection and bond sales. But is the circus currently constructed around government taxing and spending operations necessary? Conceptually, can the luxury of spending be liberated from the certainty of taxes?

Most academics in the neo-chartalist camp admit that there must be ‘money in the [government’s] bank’ first, but they’re more interested in the mind-expanding possibilities that a sovereign currency grants (but which the government usually ties its hands from realising). As a result, they usually consider governments with their own central banks as inseparable parts of a unified public sector. This is called the ‘consolidation hypothesis’.

On the other hand, horizontalists are sticklers for process. While they’ll acknowledge the teaching moment that the neo-chartalists are trying to share, and even support the neo-chartalists’ conclusions, the horizontalists insist on describing exactly what unfolds in practice. Sadly, the conventional wisdom extracts and combines the worst of both parties’ arguments, while the parties themselves are arguing so vocally about semantics that they become too hoarse and haggard to compete in the more important debate. Watching it unfold is like being Tim in the following scenes:

Since the conclusions from my previous point rest on reconciling a semantic point, I’m obliged to walk the tightrope once more, for clarity. So, sigh, here it goes. Enter the Dragon.

(Or is it Way of the Dragon?)

Does the government need your money? Simon and the Horizontalists

If the government needs your tax dollars before it spends, then perhaps I’ve wasted your time and confused you unnecessarily. But I’ve realised that main the difference between the neo-chartalists (or Gareth in the above video) and the horizontalists (or Simon the IT guy) is the question that they think is being asked.

Simon, the IT guy and eternal pedant, heard, “Does the government need your money in order to spend?” And his answer is, “Yes, under current government and central bank treaties and operational specifications, the government needs a positive balance in its account at the central bank before it can spend.”

Simon would argue as follows:

  1. The balance sheet operations in the previous post depict standard bond-financed deficit spending. The government needed $4 million in its account and it sold bonds, to Gail, in order to obtain these funds, which Gail created with nothing more than a ledger entry.
  2. The government could have financed its expenditure by taking a full $4 million in taxes from Trudi-Ann up front. If Trudi-Ann didn’t have $4 million to meet this hefty bill, she could treat it as an outstanding liability, make the movie, sell it to the government and pay off her taxes with the proceeds. Note that, in this situation, taxes do appear to precede government spending. (And unlike the previous option, no new money is created here.)

But that’s the extent of Simon’s operations-focused answer. Most sovereign governments currently engage in a mixture of both processes to fill their bank accounts prior to spending. They sell bonds on the secondary market (to the bank owned by Gail) and/or they tax (Trudi-Ann) first. The government does seem to need your taxes first, particularly in the second scenario.

Should the government need your money? Gareth and the Neo-chartalists

Gareth, usually correct on the moral of the story but imperfect on the details, heard, “Should the government need your money in order to spend?” And his answer: Nope. For the following reasons:

“Assistant to the regional manager.”

  1. With a sovereign currency, the government shouldn’t have to go to the secondary market (Gail) to sell its bonds. As argued in the previous post, ACT I, in which the government sells bonds to Gail’s commercial bank before the central bank buys them back, could be cut out altogether: the government could sell bonds directly to the central bank. This is sometimes called ‘monetising the deficit’ and is an almost unspeakable taboo in the conventional wisdom. But as long as the central bank drains reserves from the system (ACT I Scene 3), as it must, if it wants to hit its cash rate target, the results are equivalent. The government gets a deposit, without having to tax Trudi-Ann, while the balance sheet of the commercial bank is unchanged overall. For this reason, Gareth’s people often argue that the ‘independent central bank’ is just an illusion–if the government wants to spend, the central bank is inescapably complicit.
  2. Logically speaking, the tax take is not even ‘your’ money at all. What if the government demanded Trudi-Ann pay her taxes before it bought her movie? And what if Trudi-Ann couldn’t defer her tax payment and her bank didn’t grant her a loan? Unable to pay her taxes, Trudi-Ann would have to declare bankruptcy, while the government would collect nothing, and Stop the Boats would never become the Waterworld-topping blockbuster it was destined to be. But not because Trudi-Ann couldn’t pay her taxes to finance the film. Rather, the system would collapse because the government didn’t spend the tax money into existence first! Government and central bank balance sheets obscure the sequence of events, but logically, even for a so-called ‘taxpayer-funded’ program, spending must precede taxation.

The Bottom Line

Under current arrangements, it appears as though taxes do precede, and contribute to the finance of, government spending. But should they? Logically, it’s the other way around. Government spending happens before taxation. And in practice, after the accounting smokescreen is blown away, the amount that government spends is independent of the tax it collects. Public spending can, and should, be liberated to pursue the public purposes that you, the consenting and taxed public, are empowered to decide. So think big. As David Brent’s favourite philosopher puts it:

Appendix: two concepts of government spending and taxation

Say the government and the private sectors each start with $100 in their respective bank accounts. (This money had to be spent into existence at some point in the past, by either a central or private bank, but they’re off the scene now.)

The government wants to spend $120. In this situation, the horizontalists would suggest the following sequence of events.

  1. Start with $100 each.
  2. Government takes $20 from the private sector as tax.
  3. Government spends $120 into private sector accounts.
  4. Government offers $100 in bonds to private sector (representing the part of its expenditure not matched by taxes).

Balances are restored to their original amounts and $100 in new assets have been created.

Government Sector Private Sector
Assets Liabilities Assets Liabilities
1 Deposits $100 Deposits $100
2 Deposits $120
(incl. tax)
Deposits $80
(after tax)
3 Deposits $0 Bonds $100 Deposits $200
4 Deposits $100 Bonds $100 Deposits $100
Bonds $100

The neo-chartalists would propose the following chain of events, emphasising that a sovereign government shouldn’t need money in its account before it spends because, well, it’s a sovereign government:

  1. Start with $100 each.
  2. Government spends $120 into existence using ‘keystrokes’ (or an entry in its accounting ledger).
  3. Government takes $20 from the private sector to ensure the latter recognise that taxation is representation.
  4. Government offers $100 in bonds to mop up the excess deposits in the private sector.

At the end of this sequence, the amounts of private sector wealth, money and bonds are identical to the first case. And that’s why this argument is largely semantic and almost unnecessary.

In this neo-chartalist vision, however, the government appears to end up with $220 of deposits. How is this so? The answer is kinda zen. If the government ‘didn’t need’ the $100 it had back in Step 1, why should it ever have any amount of money in its account? If it’s spent into existence using keystrokes, government money balances are superfluous, according to the neo-chartalists. It sounds like a Buddhist proverb, but the balance sheets below depict the neo-chartalist claim that a sovereign government ‘neither has nor doesn’t have money’. It just has the power we entrust to it.

Government Sector Private Sector
Assets Liabilities Assets Liabilities
1 Deposits $100 Deposits $100
2 Deposits $100 Deposits $220
3 Deposits $120
(incl. tax)
Deposits $200
(after tax)
4 Deposits $220 Bonds $100 Deposits $100
Bonds $100

Recommended reading

The following sources, though copied from the previous post, remain as relevant as ever.

  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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