What is tax really for? Most people assume that governments need to collect tax before they can spend. But for a government like that of the UK, which issues its own currency, that is not how the monetary system works.
The UK government creates new money when it spends. Tax then takes money back out of the economy. That means we need to think very differently about why taxation exists.
In this video, I explain six reasons why we need tax.
Tax gives the pound its value because people need pounds to settle their tax liabilities.
Tax helps control inflation by withdrawing spending power from the economy.
It can reduce inequality by redistributing income and wealth.
It can change prices to discourage harmful activities and encourage socially useful ones.
Fair taxation can strengthen democracy by reinforcing the obligations we share as members of society.
And tax is one of the government's most important tools for steering the economy.
Understanding this changes the way we think about government spending, deficits, inflation and economic policy.
Tax is not simply the government's piggy bank. It is one of the most powerful economic policy tools we have.
This video is part of my Understanding Economics series, explaining economics as it actually operates in the world around us.
This is the audio version:
This infographic supports this video:
This is the transcript:
Hello, I'm Richard Murphy, and this is Understanding Economics, the series of videos that I'm making that explains how I think our economy works. And I stress that point. This is how I think our economy works because I do not agree with most mainstream economists on how the world around us creates an economy and how it functions.
I'm talking about the economy I can see, the economy I have worked in, the economy that I have studied, the economy that I have observed and written about in millions of words. And this matters because I want to talk about the economy as you will also experience it, and that is what Understanding Economics is all about.
And in this video, I want to talk about a topic which is especially dear to me in some ways, and that is tax. I was a tax specialist chartered accountant for many years. I co-founded the Tax Justice Network. I've written a great deal about tax. Tax really matters to me, but let me explain something which is absolutely fundamental about tax, which most people do not understand, and which is the basis for this video and all that follows in it.
And that is that tax does not pay for government spending. I know that 99% of people in the world think that tax does pay for government spending. And in fact, that is true with regard to subnational governments and any national government that does not have its own currency. But in a country like the UK, the government creates money when it spends by instructing the Bank of England to make a payment, and to mark up its overdraft, in effect, when it does so.
The government creates money when it spends, and tax is then used, necessarily afterwards, to reclaim some of that money back out of the economy with the purpose of controlling inflation, which would otherwise happen because there would be too much money in circulation.
So what are the real reasons for tax over and above that control of inflation, which I've just mentioned? There are six of them, and I want to explain them in detail.
The first, and one of the most important reasons why we must have a tax, is that tax gives money its value. Taxes in the UK have to be paid in pounds; the pounds that the government creates when it spends. That means people and businesses need pounds to pay their tax bills. And because everyone needs pounds to pay tax, people are willing to accept pounds when they are paid for their work or when they sell something. That is why the pound is the money we use throughout the UK economy, and tax therefore gives the money that we use, and which the government has created, its value. Tax creates value for the pound.
The second reason why we have tax is one I've already mentioned. Tax helps control inflation. As I've just noted, the government spends new money into the economy whenever it makes a payment. Tax takes some of that money back out of the economy, leaving people with less money to spend. A problem can arise when people have too much money in an economy and try to buy more than that economy can produce. The problem in question is, of course, called inflation.
When there is not enough available to meet demand, prices can rise. Tax can reduce that pressure by taking money out of circulation in the economy, and so tax is, above all else, our primary instrument for controlling inflation inside the economy.
And as a matter of fact, it works. Most of the time, except when we have external price shocks in the UK, we have remarkably stable inflation. Tax as an instrument to control inflation is amazing; so amazing, we don't notice that it works, and that's the problem of why we don't understand this role for money.
But tax has other purposes as well as giving the pound value and controlling inflation. Tax can reduce inequality. As a matter of fact, and we've all seen this, markets can make some people very much more wealthy than others and can give enormous incomes to some and leave others in poverty. Tax can reduce the gaps created by the market in this way by asking for more from those who have the ability to pay it and by asking for less from those who have very little. In this way, tax can reduce inequality of both income and wealth. Tax can also reduce the power that comes from having very great wealth. In this way, tax can also create a level playing field within our society, which would otherwise not exist. Tax can therefore help create a fairer society, and that is one of its purposes.
The fourth purpose of tax is to change prices. Now we're not talking about inflation here; we're talking about deliberately repricing some goods and services that are available in the marketplace because sometimes markets do not price products in a way that truly reflects the full cost of the product or service that is made available.
For example, we could buy fuel for our cars, and pollution would result. And if we did so and there was no price correction as a consequence of tax, we would be underpaying for the full cost of the petrol, diesel or whatever else it might be that we're buying to fuel our car. Tax can then correct for that price failure, and we know that it can be used for this purpose. It's also used for alcohol, tobacco, and gambling. These are made more expensive by tax so that people use less of them.
And at the same time, tax can also be used to encourage things we want to consume more of, such as healthcare, education, and green investment. Tax can therefore change prices to encourage better choices that markets by themselves cannot deliver. That is a major role of tax.
And tax can strengthen our democracy. Tax creates a link between people and government. When people pay tax, they expect the government to explain what it is doing. They also expect everyone, including the wealthy and companies, to follow the same rules as they do. People who avoid tax try to escape an obligation that everyone in society is meant to share. Fair taxation, therefore, helps strengthen our shared responsibility, and so our democracy. We have a stronger society if people understand that tax is a mutual obligation that creates a public good, our fair and democratic world.
And let me explain the last reason for tax, and that is that tax helps steer our economy. As I've already noted, tax can be used by the government to help manage the economy. Higher taxes can reduce spending. When there's too much money in the economy chasing too few things, it can control inflation. Lower taxes can leave people with more to spend when the economy needs support, in other words, when there's a recession. But taxes can also discourage things we want less of, I've mentioned this too, and encourage things we want more of.
But at the same time, it can do something at a bigger level. These issues can happen at a microeconomic level in the market. They can happen at a macroeconomic level when the government changes overall rates of tax that it tries to take out of the economy. Tax is therefore like the economy's steering wheel. It's not the government's piggy bank. It's the way in which the government can steer us in the right direction when the economy will, by itself, go in the wrong one.
This was the great discovery of John Maynard Keynes in the 1930s, when the UK government was trying to withdraw from the economy during the Great Depression of that decade. He said, get back in there. Use tax, use spending as the mechanism to ensure that the government can put the economy back on track. Tax is an essential part of that process.
So what makes a good tax? We should not just judge a tax simply by asking how much money it raises. Raising money is not in itself the purpose of any tax, although it is of course a common characteristic of all taxes. We should ask instead what the tax is meant to achieve.
Does it help control inflation?
Does it reduce inequality?
Does it provide value to the pound?
Does it change harmful behaviour?
Does it strengthen democracy?
And does it help the government steer the economy?
Those are the six questions we should ask when deciding whether a tax makes sense.
Tax does not pay for government spending.
It gives money value.
It helps control inflation.
It reduces inequality.
It changes prices.
It strengthens democracy.
And it helps the government steer the economy.
Those are the six reasons why we tax. We do not tax to fund government spending. That is a myth. These are the realities. Understand that, and you will understand economics better.
That is the goal of the videos in this series, and you will find a playlist down below of all the videos in this series, and I'd suggest you go and have a look at them. They are useful. Start at the beginning. They are recorded in a particular order to be useful, and I hope they help.
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I think the point you make about tax being so effective in controlling inflation that we don’t notice this major role is particularly good and should be emphasised a lot more. In this respect, like the carbon cycle (before humans messed it up).
I think it is true?
‘Cannot be said enough in these times.
Having read ‘The Joy of Tax’ something was also said about the virtuous money creation/tax cycle also helping to keep the value of the pound robust in our society (the preferred curency) so that people continued to use it?
If applicable now (and I know that your immersion with these issues can change your perspective) then the threat posed by crypto becomes more ominous, when capital wants sovereign money creation and tax got rid of by tying it up in knots (making it look as though it does not work), or that there is a problem and we need ‘more resources’ (the big lie behind privatization getting traction). Crypto will I’m sure be sold to us on this basis.
“I know that 99% of people in the world think that tax does pay for government spending. And in fact, that is true with regard to subnational governments…We do not tax to fund government spending. That is a myth.”
I get the main point and, of course, it can’t be said often enough. But I think this talk really buries the important distinction between national governments that create their currency as they spend (e.g., the UK and the US), i.e., currency issuers, and subnational governments that don’t and can’t, i.e., currency users (like the rest of us). It’s stated right there in the quote so the distinction is acknowledged but it’s also stated three times that “taxes do not fund government spending”—and that’s simply not true if the government that is spending is “subnational” (or does not create its own currency when it spends). Obviously, you’re trying to rebut a larger myth but I think a bit more clarification and qualification might have been helpful, especially for people for whom all this is new.
The point is true.
In countries like the U.K., the vast majority of sub national government spending is funded by central government.
I follow your blog because I think you sometimes write good articles, but this one left me speechless. How can you say with such confidence (almost delusion) that tax in national governments doesn’t pay for public spending? What makes you think you’re cleverer than 99.9% of economists?
If Governments want to spend money, they have three options to fund it:
(a) tax,
(b) borrow, or
(c) create new money
(c) is indeed a feasible option. But the old-school ‘printing new money’ is no longer the norm in any serious country. It leads to hyperinflation if the country isn’t producing enough domestically because its currency loses credibility (and value) in the eyes of the rest of the world, making paying for (imported) inputs even more expensive – see Germany after WW1 or Venezuela in the times of the Bolivarian Revolution.
Option (b) – borrowing – is what the USA does. Only they can pull it off given the dollar’s status as a world reserve currency: any other country would’ve had a currency run a long time ago given its debt’s inexorable upward trend. But even the USA is having to face borrowing costs not experienced in decades.
Yes, when receipts have plummeted, like after the 2008 financial crisis or during the pandemic, Quantitative Easing has enabled governments to sustain great deficits. But that added to debt anyway, and created new money only at the margin. The BoE bought gilts using existing money – banks deposits that were forcibly kept as reserves with the BoE, creating only new money to pay the banks the base rate on those reserves. But QE ended and since 2022 is being reversed. So all that’s left, given the high levels of debt across the developed world, is taxing to fund public spending.
You accuse me of delusion, but you have avoided the most basic question: where do you think the money comes from in the first place?
If tax supposedly provides the money government spends, where did taxpayers get the pounds with which they pay their taxes? And if government borrowing provides the money, where did the people buying the bonds get the pounds with which they buy them?
You cannot explain a monetary system by assuming the money already exists.
The evidence is straightforward: the UK government can and does create sterling when it spends. Taxation subsequently cancels money. Bond issuance exchanges money for another government financial asset, a gilt. Neither operation provides the government with something it is incapable of creating itself.
Your account of QE actually demonstrates the problem. The Bank of England did not buy gilts using some pre-existing pot of commercial banks’ money. It created hundreds of billions of pounds of new central bank reserves to pay for them. That is precisely what QE was. The BoE said so. Are you saying they lied?
Of course excessive government spending can cause inflation when it creates demand beyond the economy’s capacity to supply. I have said that repeatedly. Germany after the First World War and Venezuela do not alter the accounting of how modern money is created.
So forget whether I am “cleverer than 99.9% of economists”. That is irrelevant.
Answer the much simpler question: where do you think pounds come from before anyone can pay them in tax or use them to buy government bonds?