Part 2. Do taxes fund spending – does the budget need to be balanced?
Another misconception about public finances is that the government raises taxes in order to have money to spend – and that the gap between the two must be bridged via borrowing or else there would be no money.
But given the Bank of England can always create money to finance government spending, this is not actually the case. In reality, taxing, spending, and borrowing all happen at the same time. It’s not necessary for the government to first collect taxes and borrow, to then have money to physically spend.
In fact, private banks work in a similar way. They don’t actually need deposits in order to lend out money – they can simply credit customer accounts through a computer regardless of the amount of deposits they hold.
While governments can also create money, the constraints on their spending are quite different to those of private banks. If governments spend above and beyond the productive capacities of a country (so the additional spending can’t be absorbed by businesses hiring more people, or using up idle resources, for example) inflation can become a threat. Taxes can be increased to slow down investment.
So taxes are not a means of raising money per se, but rather a tool the government can use to control phenomena that affect the real economy. Whether the ‘books are balanced’ or not isn’t what really matters. We should instead be asking whether government spending is being allocated in a way that benefits society.
Imagine the real economy as a plant, which is watered via a watering can (the government). The volume of water the can contains is controlled by the central bank. The plant grows if the government uses money created by the central bank to invest in productive assets and nurture the real economy. Importantly, taxes are the drainage holes in the plant pot. This is because if the central bank allows money creation, the government does not actually need taxes to finance spending. Rather, it could finance it all through money creation, using taxes as a lever for redistribution and to ensure that the economy does not overheat – or in line with the analogy – that the plant doesn’t drown.
During recessions, the economy is performing below its potential, with significant productive capacity sitting idle – what is known as the output gap. The plant’s growth is stunted. If the central bank is incredibly frugal with how much it allows the government to spend, the plant will never grow – the economy is going to remain stagnant and huge swathes of society will suffer.
If the central bank lets the government fill up the watering can itself and spend on endeavours that don’t grow the economy, the plant will be overwatered. The pot will overflow, inflation will run rampant and the plant will drown. But if the government is allowed to spend in the right way, there is no reason why large programmes of fiscal spending are problematic. The pot will fill to a reasonable level, nurturing a strong, resilient plant. When the pot either looks a bit too full, or the water too unequally distributed, the tax drainage holes can be expanded to extract money from the economy to prevent inflation, or to redistribute accordingly.
This analogy demonstrates how government spending is not circular – the state does not collect taxes and then spend those taxes; it does not have to ‘find the money’ before it can spend. Rather it spends money into existence, and taxes it out of existence. Because of this, balancing spending and taxes (‘balancing the budget’) is not what really matters as an ends in and of itself. Adjusting those two mechanisms in a way that benefits the economy is what is vital here, rather than minimising the difference between them at all costs.
In theory, being the custodians of the tap, the Bank of England imposes borrowing limits – by choosing how much debt to buy up and by requiring that debt be repaid – in an attempt to maintain financial stability (their chief mandate). To fulfil this mandate, it is important to balance the need for government spending with the much-debated risks attached, including impact on the interest rate, inflation, impact on the exchange rate and the burden of debt repayment on future generations.
Most governments also set their own fiscal rules to try to control spending, which are being reviewed in the UK at the time of writing. While some form of rules around public spending is important to ensure political accountability, it is debated whether a primary focus on fiscal targets that purport to maintain stability (but are actually quite arbitrary) are really appropriate objectives for government policymaking. Participants in this debate tend to fall into one of two camps: proponents of ‘sound finance’ vs proponents of ‘functional finance’. The minority flying the flag of ‘functional finance’, theorised by Abba P. Lerner ( and advocated by followers of Modern Monetary Theory), argue for policy to focus on economic results (full employment and then stable inflation), rather than balancing the budget. In contrast, ‘sound’ finance targets a balanced budget, and expenditure, debt and/or revenue rules.
Lurking behind each of these opposing perspectives – one idealising a world in which deficits are eliminated, one a world in which deficits are often preferable – are conflicting ideas about whether it is monetary or fiscal policy that should dominate macroeconomic management. And underpinning those alternate perspectives are distinct assumptions about how the economy works. This cuts to the heart of discussions in the economic sphere about the optimal size of stimulus required for a swift, stable and fair recovery to the covid-induced recessions we are experiencing around the world.
There is an important distinction to be made here about on the one hand pluralism within economics, and on the other the hand opacity of economic concepts and how they are commonly (mis)represented (and therefore (mis)understood). It’s commonly conceived that taxes must be raised to pay for spending, rather than used as a tool for maintaining macroeconomic stability. But only once the concepts of taxes, government debt and deficits are de-mystified can we then lift the hood on the real debate happening in the economic sphere, where perspectives of opposing economists on subjects like taxes, debt and deficit boil down to fundamental assumptions about the way the economy works.
Things to think about
- Why do governments have to pay interest on debt they owe to themselves? Do central banks ever write off government debt?
- How do countries without central banks fit into this? E.g. developing countries, the EU?
- Why does the media perpetuate household metaphors when this is not how government debt really works? How can economists effectively shift this narrative when it is so ingrained?
- Debate about implications of large fiscal stimuli continues between prominent economists: what degree of threat do different consequences of large programmes of government spending pose?
Further reading/watching/listening for this blog series
- Exploring Economics events:
- Understanding Pandemic Response: The Modern Money Theory Perspective (L. Randall Wray)
- Inside the Black Box: the public FInances after Coronavirus (Jo Michell)
- Monetary Policy in a Pandemic (Josh Ryan-Collins)
- A Conversation with Lawrence H. Summers and Paul Krugman – opposing views on the optimal size of the Biden stimulus
- Review of Stephanie Kelton’s ‘Deficit Myth’, a book debunking 6 myths purporting that government deficits are inherently bad
- Against MMT (James Meadway)