Have you ever noticed a pundit or politician talk about public spending, or funding, or money; then correct their word choice from ‘public’ to ‘taxpayer’?
Obviously these two terms evoke different ideas. ‘Public money’ collectivizes the endeavor — we’re funding this as a nation. ‘Taxpayer money’ by contrast clearly emphasizes that the money being spent came from hard working individuals.
So it’s about how one wants to frame the argument. Politicians trying to sell a government program might go with the ‘public’ frame, while those opposing it might balk at the cost to the ‘taxpayers’.
But despite the different framing, in this context the terms are basically synonymous, right? Not quite. When talking about federal spending, federal taxes, the ‘taxpayer’ framing doesn’t hold water.
In my first post I asserted that Canadian public debt is best understood as all of the Canadian dollars the federal government has spent into the economy that it has yet to tax out. I’m expanding on that in this post to explain why taxpayers don’t pay for federal spending, and how we knew this over 70 years ago. I’ll give a brief description of how money transfers between the government and its central bank, commercial banks, and individuals.
When Government Spends
First, spending. This could be to purchase goods or services for the government, to pay wages of people on its payroll, or to service social welfare for those who receive it.
The government instructs the central bank (Bank of Canada) to debit the treasury’s (the Receiver General) account and to credit the account of the recipient. Simultaneously, the reserve account of the recipient’s bank gets credited at the central bank. They create money, with keystrokes, by assigning it to recipients.
Central bank reserve accounts are essentially chequing accounts for commercial banks, mainly used for interbank transfers. They are an asset of the bank while the deposit accounts of customers are on the liability side of the ledger, so this operation is cost-neutral to the banks who are acting as an intermediary between the government and the recipients.
This operation also leads to a net increase of reserves in the banking system. When we have excess money in our bank account, often the smart thing to do is to move them to a savings account that offers modest interest but is just as safe as keeping funds in a non-interest paying chequing account. It’s no different for commercial banks: excess reserves don’t accrue interest.
As a sidenote: some central banks now do pay interest on reserves, and some are taxing them, as part of unconventional (read: desperate) monetary policy. The Bank for International Settlements recently said that central banks are running out of policy options, so it’s not working that great.
Excess reserves are an opportunity cost to banks, so they will gladly purchase government bonds with the reserves: move money from their chequing account to a savings account.
Another myth is that government bonds are issued to finance spending with debt, perpetuated by the Bank of Canada itself, but other central banks are coming around to admitting that is not the case. In reality, it’s got everything to do with BoC’s central mission: to maintain the target interest rate set by the central bank. Bonds are issued in order to drain reserves out of the banking system, and so long as banks have excess reserves there is demand for bonds.
Which gets us to the point that all money is a debt, an IOU, of the government. The loonie in your pocket is part of the national debt, it just doesn’t carry an interest.
More on bonds by Bill Mitchell here: There Is No Need To Issue Public Debt
When Government Taxes
Taxation is simply the inverse of spending. Bank accounts and the corresponding banks’ reserves are debited. This reduces the government’s liability, or what is colloquially known as the ‘national debt’.
Keep in mind the federal government doesn’t need money to operate. When it needs money, it creates it by spending it into existence. So what’s the inverse of creation?
That’s right: federal taxes destroy money. Simple as that.
Federal taxes don’t finance federal spending.
So what are they for?
Lessons from history
Remember when I said we knew this 70 years ago?
Beardsley Ruml served as the Chairman (1941-1946) and Director (1937-1947) of the Federal Reserve Bank of New York. At that time, as now, the US was monetarily in a similar situation as Canada is now: it was a monetary sovereign.
For monetary sovereignty, the following conditions must apply:
1. The country issues its own national currency.
2. The value of the currency isn’t tied, or ‘pegged’, to the value of other currencies. Known as free-floating exchange rate.
3. Not convertible to commodities like gold or silver.
Aka. Fiat money.
The gold standard had collapsed internationally during the Great Depression, and certainly would have made it difficult to finance the US participation in WW2. The gold standard and fixed exchange rates would be resurrected under the Bretton Woods agreement until the 1971, but Ruml knew then what most economists today apparently don’t know or don’t care to admit.
In 1945 in a speech he declared: “Taxes for revenue are obsolete”. You can read his article with the same topic here.
I’ll quote Warren Mosler’s summary, but I urge you to read the article itself (emphasis mine):
As Ruml’s stated, with 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… It follows that our Federal Government has final freedom from the money market in meeting its financial requirements… All federal taxes must meet the test of public policy and practical effect. The public purpose which is served should never be obscured in a tax program under the mask of raising revenue.” He goes on to explain how, with Federal spending not revenue constrained, the first function of taxation is to regulate the value of the dollar, which we know as regulating inflation. The notion of the Federal government ‘running out of money’ and ‘dependence on foreign borrowing’ as well as ‘sustainability’ is categorically inapplicable.
Ruml asserts four principal purposes for federal taxes, none of which are about revenue:
- As an instrument of fiscal policy to help stabilize the purchasing power of the dollar;
- To express public policy in the distribution of wealth and of income, as in the case of the progressive income and estate taxes;
- To express public policy in subsidizing or in penalizing various industries and economic groups;
- To isolate and assess directly the costs of certain national benefits, such as highways and social security.
Taxes create demand for the currency
Other than what Ruml had to say about, at the most basic level taxes have an incredibly important function: they create demand for the currency and so enable an economy of exist. This is often summed up by the phrase: taxes drive money.
How to get a currency accepted by the populace in the first place, be it the Canadian pound or dollar? Simple. Impose a tax obligation to be paid in the new currency, and you’re done. You’ve created demand for the currency. As long as the state is credible enough, people will generally prefer paying taxes to imprisonment.
Luckily, most of us would agree that taxes are a small price to pay for the utility we get from stable money, and government structures and services.
One Canadian dollar, then, is a debt of the Federal government that you can use to pay off one dollar’s worth of taxes. An IOU of the government that you can use to redeem your own IOU (tax obligation) to the government. One dollar’s worth of tax credit.
The federal government does not require tax revenue to finance its spending. Taxes are what give value to the currency in the first place, and they relieve inflationary pressure by removing money from the economy.
In case of a budget deficit, the federal government will ‘borrow’ the balance by issuing bonds. But this is done in order for Bank of Canada to maintain its interest rate, not to finance the spending.
The above is the description of actual monetary operations done in a modern central banking system. At risk of repeating myself, it tells us that taxes don’t finance the federal government. And unlike the abstract version of government finance we’re taught and is hashed out in media and political stage, it has the benefit of being factually correct.
So good news for the people who like to identify themselves as taxpayers: your money doesn’t fund ANY of the federal programs, doesn’t go to any people or provinces or companies you find undeserving. Your tax liability is an asset of the federal government, and by paying it off you are doing your part in maintaining the value of the currency. It also means that at least some of your current tax burden might indeed be unnecessary, unfair, and a drag on the economy. The Canadian Taxpayers Federation should be ecstatic! Unless, of course, they are just a front group for a particular political ideology.
None of this means we shouldn’t worry about inefficient, corrupt, or unfair spending and taxation. On the contrary, it should necessitate more engagement and more transparency. But it does mean that when spending is proposed, the first question shouldn’t be “Yeah? Well how do you suppose we’ll pay for it?”. Both taxes and spending should fulfill the requirement of public purpose, as guided by the needs and desires of the electorate and by established human rights.