It is increasingly common to hear that “taxes don’t pay for government spending.” The idea that tax increases are at best unnecessary, and at worst actively damaging, is gaining influence on the left. The Treasury has recently floated the possibility of tax increases that include the removal of loopholes that benefit the wealthy. It is noteworthy that these changes are being considered by a Conservative chancellor. How should Labour respond?
So far, the official line is that tax rises are not appropriate given the current economic crisis: Starmer’s spokesperson said that it is “absolutely the wrong time to be talking about tax rises.” This response is informed by the conventional Keynesian understanding that in a crisis driven at least partly by insufficient spending, anything that will further reduce private sector spending should be avoided. And while this has angered some on the left, who rightly regard tax justice as a priority, there is an increasingly vocal group on the left which argues against tax hikes from a different perspective.
The starting point for the argument is the claim that there is effectively no connection between taxation and the size of the public sector: government spending can be increased to any desired level, it is claimed, without needing to worry about raising tax revenues to “pay for” it. The logic behind the claim is often presented in a convoluted way, but essentially it boils down to a simple observation: the Bank of England – a public sector institution – is the issuer of pounds sterling. As long as the Bank of England is willing to issue pounds on behalf of the government, the government can spend without needing to tax.
The argument is technically correct in terms of the mechanics – the UK government will never run out of pounds. But the conclusion that “taxes don’t pay for spending” is incorrect. This is because it conflates two different meanings of “pay for.” The first is the act of settling a transaction. It is well understood by members of the public that when they make a payment – when shopping at a supermarket, for example – this will lead to changes in cash balances: the shopper’s cash, whether held physically as banknotes or electronically as a bank deposit, will be reduced and the supermarket’s balance will increase by an equal amount.
“Payment” in this sense refers to the mechanics of the transaction: does the shopper have sufficient cash (or an overdraft facility) to purchase the goods? If not, the transaction cannot take place. Given that a shortage of cash can never constrain government spending in the narrow technical sense, it is claimed, taxes therefore don’t pay for spending. Spending is instead “paid for” by the Bank of England electronically issuing new cash.
Again, this is technically correct – but it is a narrow, mechanical, and ultimately misleading definition of how the government “pays for” things. What really matters are the goods and services that cash balances purchase. The government can purchase these by printing more money if two conditions hold. The first is that there is some “slack” in the economic system: in other words, there are unemployed or underemployed people who can increase their activity to produce the goods and services. The second is that the private sector (households and businesses) is willing to hold the extra money created by the government.
To the extent that these conditions hold, there is indeed a ‘free lunch’ for the government, due to its ability to print new pounds. But while most economies do operate with some slack – there are always unemployed people – this capacity is not limitless. Eventually, a point will be reached where the goods and services purchased by the government cannot be newly produced, so the government will have to compete with the private sector for economic resources.
Likewise, the willingness to hold cash balances is not without limit: at some point, those holding newly-created pounds will use these balances to spend on goods and services, or to purchase assets such as houses or stocks and shares. Investors may sell pounds in exchange for other currencies, reducing the international value of the pound.
There is, therefore, a limit to the extent to which the government can “pay for” its spending by printing new money. Beyond this limit, the government must either borrow, or tax. This is the sense in which tax “pays for” spending: it makes economic resources available to the government that would not otherwise be available.
By levying taxes, the government can reduce the spending of some individuals, or reduce spending on particular goods and services. For example, by taxing those on higher incomes, consumption on highly-polluting luxury consumption may be reduced. This means more resources are available for other activities, such as building transport infrastructure or providing for the consumption needs of care workers.
The climate emergency and the pandemic require a fundamental restructuring of the economy. The scale of investment needed means that bottlenecks are inevitable, requiring reductions in expenditure elsewhere. More home insulation may require fewer new kitchens to be installed, for example.
It is misleading and unhelpful to claim, for example, that a Green New Deal can be implemented without taxing the wealthy: the monetary mechanics are largely irrelevant – what matters is that the wasteful consumption of the wealthy must be reduced to make resources available for socially-useful spending.
The changes mooted by the UK Treasury include aligning capital gains tax with income tax, removing additional pensions relief for the better off and increasing corporation tax. These are progressive changes and long overdue. The changes also attract widespread public support. Opposing them means siding with wealth over work and rich over poor.
At the same time, progressives must continue to argue for fiscal activism to maintain jobs and transform the economy. Claims that pandemic-induced increases in public debt need to be “paid back” are simply incorrect and should be refuted.
The public deficit will remain large until the crisis is over and the debt to GDP ratio will rise – that is exactly as it should be. The Bank of England can and should continue to use its money-issuing power ensure that the expansion of public debt can take place without generating financial or economic instability.
But tax revenues and the size of the state cannot permanently diverge. Those who want to see a larger and more effective state need to make the case for progressive changes to the tax system that will ensure that revenue grows at approximately the same rate as expenditures over the long run. This is not to say that the two should be equal: they should not. A public deficit has been the normal state of affairs for decades – but deficits cannot grow without limits.
We must not allow misguided arguments about “tax not paying for spending” to erode the tax base, increase inequality and open the door for free marketeers to argue for the need to cut back on essential social programmes. If we want to see systemic change, it’s time for the left to argue for progressive tax reform on it own terms.