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I was asked recently what is the difference between tax-and-spend and spend and tax when it comes to economics and modern monetary theory?
The person who asked me said it's all just semantics, isn't it? It doesn't really make a difference. Well, the answer is, it does, because the government always spends first and taxes later. And it has to, because if it didn't spend first, there would be no money available with which to pay the tax, and that's important because ordering does matter in economics.
The order tells us whether we are describing reality or pretending something else happens.
Now, just have a little thought exercise here. Imagine you are driving in the UK and you approach a roundabout, and you want to get to the opposite side.
We know what the correct route is. You turn left and go around the roundabout, the proper way. Everyone understands what you are doing. The rules of the road are respected. Traffic flows safely. And you reach your destination. That's what spend and tax describes. It literally describes the reality of the way the world works, and policy respects that reality, and so outcomes are predictable.
But the alternative is that you do what economists claim and go the wrong way round the roundabout. You turn right. You ignore reality. You pretend you make the rules. You claim the system works differently to everybody else, and chaos, of course, follows.
This is what tax-and-spend economics does. It refuses to accept how money actually enters the economy, and policies built on that misunderstanding lead to bad decisions and, even, and let's be clear about this, crashes because that will probably happen on your way around that roundabout.
Confusion, economic damage, and crashes will result from getting this understanding wrong.
So we face a choice. We can design economic policy around how the monetary system really works, or we can keep pretending that it works the other way around.
We can crash, or we can get safely to the other side. Which approach should we use to run the economy? There's a poll down below, and I'd really like to know what you think.
Poll
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Let’s continue your analogy….
The neolib economists say … Lets imagine a roundabout. In a hypothetical ideal, so there is no other traffic. And therefore,QED, it doesn’t matter what way round you go… But since all the Oxbridge dons told the economists that “anticlockwise is best for the UK”, we’ll need to try to do that. Otherwise other folk are being in our ideal traffic environment/market.
Ok …. On a more serious note: neolibs say: the order of money creation is just semantics. Let’s take a snapshot in time: there is money in the system, so does it matter where it comes from? …. (I reckon) Well yes … Cos it matters what the priorities are for the people who have the money – that defines where it is or isn’t spent (and in today’s politics, what rules are used to avoid different distributions of that money). Its not just that money exists.. but also the distribution and ability to avoid that being used badly.
Thanks
I quite like the bath-tub analogy.
Water flowing into a bath is similar to government spending.
Water flowing down the plug-hole is similar to taxation.
The water level in the bath is the money in the economy that makes it work (the “national debt”)
You can’t fill a bath by just recycling the waste water.
I like….
Not sure if Zack Polanski would be able to use this analogy (or Richard’s magic roundabout) to explain how the Greens would fund increased public spending to Laura Kuensberg or a Newsnight presenter?
Probably not.
But I liked it.
As a BBC report showed (profiled recently on this blog), most presenters/journos in the BBC know less about government & finance than most of the commentators on this blog. Furthermore, the MSSM tends to deal in sound bites (= propaganda) which mitigates against explanations – after all, can’t have UK serfs educated. Dearie me no.
MSM get away with the phrase ‘fiscal headroom’. I thought I knew until I recently saw Simon Wren Lewis’s description of it. And no, I don’t know what is. I don’t believe anyone in the media knows either. It is not a buffer that protects the government from a collision. It is a thermostat that regulates the pipes of a building while we live in the outside world.
It is a made upo number to justify austerity
Richard, I do understand that the spending happens first, then taxation withdraws money from the economy to control inflation (tell me if I’ve got that wrong). But I’m not clear how this works in practice when, for example, the government wants to invest £20 billion into the NHS. I know they can instruct the Bank of England to create the money by putting it the appropriate NHS bank accounts, with a balancing debit I the government’s account – effectively creating an overdraft. Would the government then sell government bonds and/or deposit tax payments received to pay off the overdraft? And if taxes are not used to pay off the overdraft and reduce the debt where does it go when HMRC takes my monthly income tax payment? Sorry for the long question but I just don’t know how I would explain it to a potential Green voter on the doorstep.
Clive
You have the sequence broadly right, but the accounting is often misunderstood, so let me clarify it.
When the government decides to spend, for example £20 billion on the NHS, Parliament authorises that spending and the Treasury instructs the Bank of England to make the payments. The Bank credits the reserve accounts of the commercial banks used by NHS suppliers and employees, and those banks credit the accounts of the recipients. New money has been created in the process.
At that point the government’s account at the Bank of England moves into what is effectively an overdraft position. But that is not a problem in itself. The UK government, through the Bank of England, is the issuer of the currency.
Government bonds are then issued by the Debt Management Office. Their primary purpose is not to “finance” spending that has already happened, but to manage the level of reserves in the banking system and help the Bank of England maintain control of interest rates. In other words, bonds are part of monetary management, and nothing more.
Tax works differently again. When HMRC receives your income tax payment, the reserves used to settle that payment are removed from the banking system and the government’s account at the Bank of England is credited. In practical terms, the money is extinguished from the private economy.
So taxes do not “repay” government spending in the household sense. What they do is withdraw spending power from the economy. That helps control inflation and creates space for public spending.
Explaining it this way on the doorstep is actually quite helpful: government spending puts money into the economy; taxation takes some back out again so that inflation does not get out of control.
Richard
Thank you Richard for spending time to write a full answer to my long question. It made the intricacies of government finance a lot clearer, although I suspect I will have to read it a few times to fully understand it. I still think, however, that the whole neoliberal household budget framework, controlling public debt, raising taxes to pay for public spending, using interest rates to control inflation and so on, is so entrenched in the minds of our politicians, journalists, and supposedly independent economic think tanks (IFS, Resolution Foundation), that the Greens may have to stick to the narrative that increased public investment would be paid for by the multiplier effect and by raising billions of pounds in extra taxes by creating a truly progressive tax system where the wealthiest 10% of the population made the greatest contribution to public finances.
They don’t need to do that.
People have realised that narrative is wrong.
Apologies if I am being a bit dense but I still do not get it.
Using the bathtub analogy, the government can pour as much money as it likes into the bath but in doing so will probably have to let some of that water out through the drain if it doesn’t want to risk inflation.
Being simplistic, the way the water is let out is through the taxation of somebody or something or other.
Does this mean that there is generally a strong correlation between significantly increased spending and someone somewhere paying more tax to maintain the bathtub level? (unless the increased spending means that more people are paying tax so the rate doesn’t need to change?)
You are not being dense — the question is reasonable, but the “bathtub” analogy can mislead if it is taken too literally.
Government spending does add money to the economy. Tax does remove some of that money again. In that sense the analogy works.
But the crucial point is that there is not a mechanical link between a specific increase in spending and a corresponding tax increase somewhere else. Governments do not normally raise taxes every time they increase spending.
What matters instead is the overall balance in the economy.
If the government spends more but the economy has spare capacity (unemployed labour, idle factories, underused skills) then that spending can increase output without causing inflation. In that case there may be no need to increase taxes at all.
Tax becomes important when total spending in the economy is pushing up against real limits — when there are shortages of labour, materials, energy or productive capacity. At that point taxes can be increased, or targeted, to reduce demand and relieve inflationary pressure.
So the relationship is indirect. Taxes are used when needed to manage inflation, not automatically to match spending pound for pound.
There is also another factor you mention: growth itself increases tax receipts. When employment rises and incomes grow, the tax system automatically withdraws more money from the economy without any change in tax rates.
So the real rule is this: government spending is determined by what society needs and what resources are available. Tax is then adjusted, when necessary, to keep inflation under control.
Ultimately I agree that you are correct about not trying to deceive people on the doorstep about MMT and trying to honestly explain how things do work, but I have to admit this does worry me. I have numerous friends who I have explained MMT to who just don’t get it, and think I’ve taken on a wild and dangerous philosophy.
In the mainstream media this is even worse. Just yesterday old Rory Stewart was lamenting the success of “extremists” in political polling (Greens and Reform). Was his concern mainly about the fascists who would deport British citizens? Of course not! His main concern was the “dangerous” economic policies of the Greens which will lead us to ruin!
It’s people like Rory that worry me most about economic messaging. It’s why I’ve thought maybe trying to sneak MMT in through the back door was the way to go, but I just can’t support any dishonest messaging, so we’ve got to tackle it head on I suppose. It’s a concern though.
The arch-neoliberals were alwys thus, portraying their enemeies as the harbingers of destruction when that is what hey have delivered.
There is always this problem when seeking to change the narrative. We will get there.
It’s a more than decent analogy in my view.
The other thing tax and spend does is enter the roundabout at too high a speed – there is no slowing down, assessment of risk or anything, just an assumption, ignoring other users and ‘rights of way’ just like people do on real traffic islands.
My dad described an incident from his youth where a friend of his decided to reverse back round a large roundabout as he had missed his turnoff. It did not end well!
I often think of the economy as a swimming pool with a deep and shallow end. The many in the shallow end struggle to keep swimming it the water level drops while the few lucky enough to be swimming in the deep end continue to happily swim oblivious of the plight of the many.
Slightly off topic, as I recall that comment about the roundabout last weekend at Cambridge.
Something else struck me when a comment was made about the suggestion that cash ISAs could be invested in socially useful projects. The comment was along the lines of:
“But you said the government can and should create money to fund socially useful projects. It doesn’t have to borrow”. Some seem to have inferred from your explanation that this is the only way to fund such things. They have not understood that government creating money is just one was of doing things, and that there are other tools in the kit.
Money can be saved constructively, as capital funding investment. Very little is, but it csn be. I do need to get back to this. Thanks, Helen
Is there a once daily reckoning at the BofE govt bank account?
A. When the taxation input arrives as a credit does it mean that some of the newly created money ready for spending is withdrawn so that fewer bonds need to be sold at the end of the day?
B. If the tax receipts are higher than expected spending does the tax money actually create an overnight govt balance for the next day?
C. Or do they use the taxation money to buy in old bonds from the market ? But by doing this in cancelling the bond new money would enter the system (…..??)
OR??
There is not quite the simple “end-of-day reckoning” that people often imagine, but there is a daily cash management process between the Treasury, the Debt Management Office (DMO) and the Bank of England.
The government holds its main account at the Bank of England, called the Consolidated Fund / Exchequer account. During the day two things happen continuously.
First, government spending is settled. When the Treasury authorises a payment, the Bank of England credits the reserve accounts of the commercial banks receiving the funds, and those banks credit the final recipients.
Second, tax payments arrive. When HMRC receives tax, the commercial bank involved transfers reserves to the government’s account at the Bank of England. Those reserves are removed from the banking system.
So to your specific points:
A. Yes, in effect. If tax receipts are higher, fewer reserves remain in the banking system. That can reduce the need for the DMO to issue short-term gilts or Treasury bills to drain reserves.
B. Yes. If receipts exceed payments on a given day the government’s account at the Bank of England simply shows a higher balance. That balance is used in the following day’s cash management.
C. No. Tax receipts are not used to buy back bonds. Bond issuance and buybacks are separate operations run by the DMO to manage liquidity and support interest-rate policy.
So the key point is this: tax primarily drains reserves from the banking system, while bond issuance helps manage the remaining reserves so the Bank of England can maintain its chosen interest rate.
I used to think that MMT said that when tax is paid to the government the money is destroyed. From what you have said Richard that is wrong. The money is taken out of the private sector but the government has it. Is that correct?
What MMT says is slightly more subtle than either of those descriptions.
When you pay tax, your commercial bank transfers reserves to the government’s account at the Bank of England. From the point of view of the private sector, that money has gone. The bank reserves that supported your deposit have been removed from the banking system. In that sense the money is effectively destroyed for private use.
However, it does not vanish from the accounting system altogether. It appears as a credit in the government’s account at the Bank of England.
The important point is that this balance is not like a household bank balance that the government needs before it can spend. Government spending is authorised by Parliament and instructed by the Treasury; the Bank of England then makes the payments by crediting the reserve accounts of commercial banks.
So taxes do not “fund” government spending in the conventional sense. What they do is remove spending power from the private economy, which helps control inflation and create room for public spending.
That is why the key distinction MMT makes is this: government spending adds money to the economy, while taxation withdraws money from it.
The accounting entry may sit in the government’s account at the Bank of England, but economically the effect is that the private sector’s money supply has been reduced. ANd that is what matters with regard to economic substance.