Your Tax Dollars Never Get Spent and Government Budgets Shouldn’t Balance
Modern Monetary Theory (MMT) is based on what will be described as the Two Fundamental Truths of fiat currencies. Note that fiat currencies are openly floated means of exchange issued by governments .
These fundamentals are:
- Federal funding is not sourced from taxation.
- Governments cannot default on debt held in their own currency.
MMT is used to argue that countries like Australia should focus their monetary and fiscal policies not on balancing budgets and managing debt, but as a means to manage inflation and unemployment . It is built on the foundations of known functions of the economy, and as I will argue, should be fully adopted by all currency-providing countries as a means to better manage the public service. Its controversial status is largely motivated by oversimplification and false preconceptions.
We think of tax as a form of income and federal spending as a finite expense, indifferent to how a household or business may operate. Our political debates seem to have a perennial focus on how the party of the day is overspending, that deficits are out of control and that the nation ‘can’t afford’ ideologically unpalatable policies .
Indeed, the opening page of the Australian Government’s “Tax at a Glance” website reads: “A good tax system raises the revenue needed to finance government activities without imposing unnecessary costs on the economy” .
The language we use to describe federal government spending and the macroeconomy is wrong, backward and harmful.
When you or I receive our wages
we go to the pub some amount of money ends up in an account from which we are able to budget and make expenses from. Yet the government’s account is not held in a commercial bank. It is held at the RBA, the very institution that controls the supply of money. It the role of the taxation office, not the RBA, to keep track of who owes the government money. As such, it is simply more efficient for dollars to be removed and created when they are taxed and spent .
Yes, those tax dollars that we believe pay for roads, hospitals and bowling clubs in the seat of Mayo  don’t directly pay for anything. Instead, government “spending” should be thought of as a targeted supply of money. Unlike the limitation on our household spending, the government supply of money is bound only by policy makers.
While our elected government spends money in a targeted manner, the unelected Reserve Bank of Australia (RBA) controls money in an untargeted manner. Quantitative Tightening/Easing and Balance Sheet Expansion/Normalisation complicate this definition. Its function can be (perhaps overly) summarised as followed:
- If the elected government supplies the economy with too few dollars, the RBA will increase money supply by buying bonds.
- If the elected government supplies the economy with too many dollars, the RBA will decrease money supply by selling bonds.
- This process is untargeted as most of those who participate in the bond market are large financial institutions who then lend out this money to the wider, private economy.
The RBA also controls the cash rate and the reserve ratio. The cash rate controls the private banks’ opportunity cost of lending (higher opportunity cost causes less lending). The reserve ratio sets a limit on how much banks can loan out. Under a fractional reserve banking system this reserve ratio determines how much currency private banks have the ability to create. In the interest of simplicity, we will simplify these functions and state the RBA controls money supply.
In summary, the elected government are “experts” in the needs of the people. They have “first dips” of where and how capital should be distributed through the public service. They are not bound by a finite income. If they wish to spend more, they may issue securities to the economy, that are acquired by the RBA. The RBA, irrespective of the elected government’s budget surplus or deficit, then control money supply independently of a political agenda by giving or taking away capital supply from the economy en masse .
The relationship is symbiotic. If the elected government wish to over allocate funds, the RBA must either continue to supply money to the economy or they must allow the opportunity cost of lending (interest rates) to increase.
If the elected government wish to under-allocate funds, the RBA must either supply the economy with more currency to fill the void, or increase money supply through the private market by lowering the opportunity cost of lending.
This is the First Fundamental Truth of MMT. Federal funding is sourced not through taxation, but is gatekept by the RBA.
Granted this is not the same everywhere. Australia, like the US, Canada, Japan and UK create their own, unbacked currency. Unlike the US dollar under the Bretton-Woods system  where the currency was backed by some form of the gold standard, it is the use of taxation that gives fundamental demand, and thus, value for a currency.
In theory, if our government demanded no GST, no income taxes, no import taxes or any other guarantees for its currency to be repaid, workers and firms would have no necessity to use Australian dollars. Perhaps you work for the Australian branch of an American company, or you’re exporting goods to China, one could reasonably be paid in USD, or run their business using Renminbi. By demanding taxes paid in AUD, our government creates demand and guarantees a value for its currency.
Picture a theoretical Australian economy where taxes do not exist. Entities have no need for Australian dollars, perhaps they aren’t used at all. If this government tries to implement polices, such as building trains, or funding Medicare, engineers and doctors have no incentive to earn AUD when their business may depend on USD or Pounds.
To expand on this theoretical economy. Let’s say the economy is a “perfect” model. Unemployment is at its natural rate and inflation is at zero percent. What happens if the government is somehow able to convince the private market to take its Monopoly money and create public services? Or rather, what occurs when an economy at its full productive capacity is asked to do more?
Prices balloon and unemployment dips to unnaturally low levels. We think of this as an ‘overheating’ where supply outpaces demand, and consumers overspend. This bubble inflates until the music stops and the economy dives into recession until parity is restored . Perhaps this sounds dramatic, but this is exactly what occurred before the Great Recession, the Global Financial Crisis, the post-COVID recession and what is likely to happen over the coming year .
However, if this hypothetical government had initially been demanding taxes, unemployment would have been higher and inflation lower. There would have been room for growth in the economy and “space” for the public service. We think of taxes as creating a deadweight loss, but in a world where we value health, education and infrastructure we need taxes to create space for the public sector, not to fund it.
Currently, we believe governments have to balance taxes with spending. Instead, we should think of the public service as an essential provision that betters society, and taxation as a patriotic duty that provides legitimacy to our fiat currency and space for it to exists. The extent to which the federal budget balances is irrelevant. A government should instead be judged on its ability to balance price stability (inflation) with maintaining full employment.
In fact it is impossible for a nation with a fiat currency to perfectly balance taxation and spending every year. Think of our theoretical Australia, with no taxes and no currency. If it wants to begin providing a fiat currency, but also a balanced budget, it would need to spend as much as it taxes. If it provides a billion Australian dollars of public services in its first year, it would demand a billion dollars of taxation. By the end of each year, there would be no dollars left in the economy.
When our politicians argue that budget deficits are fundamentally dangerous, they are wrong. Before the huge pandemic-induced budget deficit, Scott Morrison’s Liberal party won the 2019 election on the back of a campaign promoting the party was “Back in Black” (i.e. taxed more than it spent) and had provided “The first public surplus in over a decade” . From the perspective of MMT, this makes no sense. Why celebrate providing less value of service, than dollars you deleted?
Politicians who advocate for budget surplus are arguing that an untargeted supply of money from the RBA is more useful to the nation than a targeted public service they lack the vision to implement.
I don’t believe politicians intentionally mislead us on macroeconomic policy. I would argue that both we, the public, and politicians are ignorant of the mechanisms behind our economy. And yes it is true, budget deficits can cause nations to fail. The 2007-08 Greek debt crisis was the result of a government unable to create a budget surplus . But the reason this became a crisis, was because Greece sacrificed its monetary autonomy when it tendered the Euro and dropped the Drachma in 2002.
Governments who control fiat currencies cannot default on debt in their own currency. This is the Second Fundamental Truth of MMT. MMT is dependent on monetary autonomy, and we should think about the economies of nations with fiat and non-fiat currencies as completely different. A diesel and petrol car may look the same from the outside, but if we don’t understand the differences of their mechanics, we’ll blow something up.
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