Politicians often tell us that we should live within our means. True enough. Unfortunately, many of them do not appear to understand what this actually entails when it comes to fiscal policy. So far as most economists are concerned, the events of the last decade have thoroughly discredited advocates of austerity. Yet, it remains quite common to hear politicians from across the political spectrum calling for reductions in fiscal deficits or even fiscal surpluses. There appears to be little awareness that, in most countries, a call for a fiscal surplus is, literally, a call for the society to live beyond its means.

A basic accounting identity

Here is a simple accounting relationship. It is an identity, true by definition:

Government Balance + Domestic Private Balance + Foreign Balance = 0

This identity composes a nation’s economy into three broad sectors. The government sector spends and taxes. The domestic private sector spends (households consume, businesses invest) and receives income. The foreign sector receives payments from, and makes payments to, domestic residents.

A sector is in surplus (its financial balance is positive) when its total spending is less than its income or revenue. Conversely, a sector is in deficit (its balance is negative) when its total spending exceeds its income or revenue. The accounting identity shows that the balances of the three sectors must sum to zero. If one sector maintains a surplus, at least one of the other sectors must be in deficit.

The domestic private sector includes all domestic households and businesses, including the households of public servants and politicians. The government sector is an entity that acts (or is meant to act) on our behalf, creating and enforcing laws and regulations, spending and taxing, and also employing a portion of the workforce. Its employees work in the public sector, but live in private households. As such, the income of public sector employees forms part of private household income, and the expenditure of public sector employees forms part of private expenditure. The foreign sector is everybody else in the world who transacts with the national economy, including overseas households, businesses, and governments.

A government surplus occurs when the government spends less into the economy over the accounting period than it subtracts out in taxes. A foreign surplus occurs when the rest of the world receives more income from domestic residents – through sale of goods and services and receipt of interest and dividends – than domestic residents receive from the rest of the world.

The identity shows that when the government and foreign sectors both maintain a surplus, the domestic private sector must be in deficit, spending more than its income. Of course, some members of the private sector can be spending less than their income. But, as a sector, overall domestic private spending will exceed income.

We could express the same thing in reverse. If the private sector maintains a surplus by spending less than its income, one or both of the government and foreign sectors must be in deficit.

In a nation with a current account deficit (meaning the foreign sector is in surplus), a demand for the government to run a fiscal surplus is actually a demand for the domestic private sector to spend more than its income. It can only do this by:

1. running down past savings, or
2. borrowing from banks or other financial institutions

If, instead, the domestic private sector behaves sensibly and seeks to maintain a surplus as protection against future unpredictable economic events, the government will be in deficit. This will be so whether or not the government wants to be in deficit, and whether or not the electorate wants the government to be in deficit. It is a simple – and unavoidable – matter of accounting.

However, at least in the case of monetarily sovereign nations – those in which the government issues its own currency – this is not a cause for concern. There is nothing inherently problematic about fiscal deficits in the case of a currency-issuing government.

 
The financial capacity of a currency-issuing government is unlimited

One reason there is such confusion surrounding fiscal deficits and public debt is that we are mostly taught to look at things the wrong way round. We are told that the government needs our tax payments in order to spend. Similarly, we are told that the government needs to borrow from us in order to spend more than it taxes.

Both these misconceptions result from looking at things upside down. It is not taxes and bond sales that enable a currency-issuing government to spend. Rather, it is government spending that makes it possible for taxes to be paid and bonds to be purchased.

In monetarily sovereign nations, tax liabilities are extinguished in ‘government money’. There is only one source of government money – the currency-issuing government.

Government money takes two basic forms. One form is ‘currency’, meaning physical notes and coins. The other is ‘reserves’, which are special balances held by banks in accounts at the central bank. Reserves are used for the final settlement of transactions, including transactions between commercial banks and the government in which the banks act as their customers’ agents (such as when banks’ customers pay taxes).

Tax liabilities can only be extinguished (i.e. finally settled) with what the government alone creates – namely, government money. When taxpayers instruct their banks to debit their accounts in payment of taxes, the banks in turn instruct the central bank to debit reserve accounts in final settlement of the tax payments. In rare cases, taxpayers might be permitted to pay their taxes in currency, in which case it will be currency that is used in the final settlement of taxes. Either way, it is government money that is required in the final settlement of taxes.

Clearly, for tax liabilities to be extinguished, government money (currency or reserves) must first exist. The private sector cannot create currency or reserves. This applies not only to households and firms in the real sector but also to commercial banks in the financial sector. Commercial banks can create deposits denominated in the national currency, but they cannot create actual currency and reserves. These only originate from the currency-issuing government. If a member of the private sector did try to create the currency, it would be counterfeiting, which could result in a jail sentence.

In a monetarily sovereign nation, the only sector permitted to create currency and reserves denominated in the national unit of account is the government sector. This means that, from inception, the government must create money – currency and reserves – before tax liabilities can be extinguished:

Government spending logically comes before tax payments and is what makes paying taxes possible.

When the government spends, one agent of government (the Treasury) instructs another agent of government (the central bank) to credit the reserve accounts of spending recipients’ banks. The central bank, in turn, instructs the banks to credit the accounts of spending recipients.

In this way, government spending injects government money into the system (in the form of reserves) and results in new income for households and businesses. This income can be used to spend, save, or pay taxes. If spent, the amount spent goes as income to somebody else who, in turn, can spend, save, or pay taxes.

Ultimately, all government money spent into the economy ends up either held in reserve accounts, swapped for currency, swapped for government bonds, or taxed away.

If the government spends more than it taxes, it is said to be in deficit. If the government’s deficit more than offsets the current account deficit, the domestic private sector is enabled to maintain a financial surplus in which it spends less than its income. Since households and businesses, and not the currency-issuing government, are at risk of insolvency, it normally makes sense for government to do this. Private sector surpluses help to cushion individuals against unpredictable events, such as losing their jobs or businesses.

It is much the same story with so-called government borrowing. From inception, it would be impossible for the government to “borrow” currency or reserves from the private sector before it had created them. Government borrowing is simply an operation in which the private sector is permitted to hold some of its savings in the form of government bonds rather than currency or reserve balances. Once reserves have been created, reserve accounts can be debited in payment for government bonds.

Here, too:

Government spending is what makes the purchase of government bonds possible.

The issuance of government bonds poses no solvency risk for a currency-issuing government. Nor does the interest owed on the bonds pose any solvency risk. Relevant questions for policymakers concern the demand and distributional effects of public debt and interest payments. It is never a question of financial “affordability”.

It is also worth noting that the interest rates paid on government liabilities are ultimately at the discretion of government. When a currency-issuing government decides (or agrees) to pay a positive interest rate on reserves or a bond, this is a decision to inject additional income (in the form of interest) into the private and foreign sectors. The government, as currency issuer, can obviously always make these interest payments (it simply involves marking up reserve accounts), though it will (or should) want this flow of payments, like all other government spending, to be sensible in relation to total spending (since some of the interest income will be spent on real goods and services) and in accord with the electorate’s priorities regarding income and wealth distribution.

 
Private debt, not public debt, can be of concern

Although financial affordability can never be an issue for a currency-issuing government, many politicians make the false claim that public debt is inherently a problem when in truth it is private debt that is potentially of concern.

Consider the following questions.

• Is it possible for households and businesses to get into debt problems?
• Can private businesses go bankrupt?
• Can individuals lose their jobs and find it impossible to repay a loan?

The answer to all these questions is clearly yes. It seems almost too obvious to mention. Private debt can be a serious issue. Households and businesses are financially constrained.

What about a currency-issuing government?

• Can such a government ever go broke?
• Can it ever be impossible for such a government to meet an obligation denominated in its own currency?

The answer to both these questions is no. A currency-issuing government is the creator of the currency in which it spends. A currency issuer is not like a household. It faces no revenue constraint.

Consider one more question about a currency-issuing government.

• Can such a government ever have more or less financial capacity to spend?

The answer again is no. Tax payments do not have any impact whatsoever on a currency-issuing government’s financial capacity to spend.

Reflect once more on the process of paying taxes. As we have seen, to pay taxes, taxpayers instruct their banks to mark down their accounts by the appropriate amounts. The banks, in turn, instruct the central bank to mark down reserve accounts by the appropriate amounts. The ultimate consequence of tax payments is that reserves are deleted from the system (government money is destroyed). Reserves, like currency and government bonds, are a liability of government to non-government and an asset of non-government (where ‘non-government’ is the aggregation of both the domestic private sector and foreign sector). The payment of taxes, by deleting reserves from the system, reduces the financial assets of non-government and reduces, by the same amount, the government’s financial liabilities. But since a currency-issuing government can issue financial liabilities denominated in its own currency without limit, the elimination of some of these liabilities has absolutely no impact on the government’s capacity to issue such liabilities in the future. The tax payments enrich no one, go to no one, and leave the government’s financial capacity to spend utterly unaffected.

An accounting record of tax payments is, of course, maintained. To keep track of fiscal actions, one agent of government (the central bank) debits and credits the account of another agent of government (the Treasury) as the government spends and taxes. The balance in the Treasury account, held at the central bank, is an asset of the Treasury and a liability of the central bank. For government as a whole, it nets to zero. It is simply an intragovernmental accounting arrangement in which one arm of government (the central bank) is liable to another arm of government (the Treasury).

It is worth observing that the balance of the Treasury account is not government money (it is not currency, nor reserves) nor any other kind of liability of government to non-government. Therefore, it is not what the government spends when it spends. Government spending, as we have seen, is conducted in government money through the crediting of reserve accounts. Since the balance of the Treasury account is not a liability of government, it cannot be government money, and so is not what gives a currency-issuing government its capacity to spend. The government money (in the form of reserves) that is issued in the act of government spending is created out of nothing (ex nihilo). This government money can be created without limit. The central bank simply marks up reserve accounts. Accordingly, a currency-issuing government can never have more nor less financial capacity to spend, irrespective of the level of tax payments.

Despite this, many politicians would have us believe that government should spend less into the economy than it deletes through taxation, perhaps on a misapprehension that this will somehow safeguard the government’s solvency.

In seeking to ensure that government never runs out of money that it alone creates (a logical impossibility), these politicians want the private sector (again, that’s all domestic households and businesses, including the households of politicians) to spend more than the sector’s income. This will push actual real-life households and businesses into debts that they may ultimately find difficult or impossible to repay, or require them to run down savings, so that the government entity – whose “income” (tax revenue) is basically an accounting construct and enriches nobody – can spend less than it taxes. And these same politicians seem to think that this will help us to live within our means.

 
All spending carries an inflation risk

At this point, a likely inclination is to wonder about inflation. Is it possible that government spending needs to be reined in to avoid inflation?

Sometimes this will be true. It will depend on the circumstances. Government spending, though, is not unique in this respect.

In reality, government spending – when conducted at market prices – carries the same risk of inflation as any other kind of spending. So long as there is idle capacity and underemployment, an increase in spending (whether public, private or foreign) will mainly induce a quantity response (businesses selling more output to customers) rather than an excessive escalation of prices.

Consider somebody who is a private tutor, or runs a hairdressing salon, or manages a supermarket, or is a newspaper magnate.

Let’s say a customer walks in off the street with $50 and asks for tutoring / a haircut / groceries / a selection of newspapers.

What should we expect to happen?

More likely than not, the customer will get some tutoring / a haircut / a cart of goods / a selection of newspapers at going prices. The quantity of output sold to customers will increase as a result. The effect on prices, in all likelihood, will be small to zero.

Exceptions will occur if and when a supplier of some good or service is at the limit of what can be physically supplied within the relevant period. Otherwise, with spare capacity and underemployed labor (including hired staff operating at less than peak intensity), output will rise with little to no effect on prices.

In other words, the constraint on government spending should be defined in terms of real resources, not finances. If there are goods and services available for sale in the national currency, a currency-issuing government can always afford to purchase them. The required money is created in the act of government spending.

It does not matter, in our illustration, whether the customer with the $50 is an employee of a private corporation, a public servant, a small business owner, a media mogul, a pensioner, a benefit recipient, or someone else. To the private tutor / hair salon operator / supermarket manager / newspaper proprietor fifty bucks is fifty bucks. Its effect, when spent, is the same no matter who spends it.

Now, if excessive inflation is on the radar, any extra spending will be problematic, whether public, private or foreign. In those circumstances, it will make sense for government either to cut spending or raise taxes. But more often than not, the level of spending is too weak, not too strong. The evidence for this is underemployment in which some people cannot find jobs and others can only find part-time positions when they want full-time employment. In any event, the case for spending cuts or tax hikes will relate to the likelihood of inflation, not government solvency.

 
Financial wealth and distributive considerations

In aggregate, the net financial assets held by non-government comprise currency in circulation, reserve balances, and outstanding government bonds. The reason for this is that all other financial assets held by non-government have their accounting offset within the non-government sector. For example, a bank deposit is an asset of the account holder and a liability of the bank, netting to zero for non-government as a whole. In contrast, currency, reserves and government bonds are assets of non-government that have no accounting offset within the non-government sector. Instead, their accounting offset is in the government sector. For example, the balance of a reserve account is an asset of the bank and a liability of the central bank. Currency, reserves, and outstanding government bonds are liabilities of government to non-government, and therefore constitute the net financial assets of non-government.

Government deficits add net financial assets, which are held in the private and foreign sectors. As a matter of accounting, the size of the fiscal deficit matches the net financial assets added to the system over the period. This is true because government spending entails an injection of reserves which will either remain as reserves or be swapped for government bonds or currency. Whether non-government holds the newly created funds in the form of reserves, currency or bonds, they are financial assets of non-government.

Following the same logic, the total accumulated government debt equals, by definition, the accumulated domestic-currency-denominated financial wealth of the other sectors. A call to raise taxes relative to government spending is therefore a call to “eliminate financial wealth” held by the domestic private sector and foreigners.

Should this ever be done? Yes, when appropriate, but never for reasons of financial “affordability”. The reason to do so would be to constrain demand or alter the distribution of income and wealth, not to provide initial finance for government spending.

For example, it might be felt that extreme inequalities of income and wealth undermine democracy. If so, it will make sense to impose higher taxes on the wealthy. Such a move should be motivated by distributive concerns, not government “finances”, since it would have nothing to do with providing initial finance for a currency-issuing government’s spending. A currency-issuing government does not need rich people’s money in order to spend. It creates its own money at will, whenever it spends.

Even in societies with equitable (or relatively equitable) distributions of income and wealth, it will still be likely that the domestic private sector desires to maintain a financial surplus as protection against future uncertainty. Except in a handful of small nations with current account surpluses large relative to their economies, a private sector desire for a financial surplus will require government to run deficits. This is the normal situation, not an aberration. And, for monetarily sovereign nations, it is not a cause for concern.

 
The crucial importance of taxation

All this raises a question. If taxes do not provide the initial finance for government spending, why are they necessary?

Taxes are actually more – not less – important than the politicians who call for austerity and fiscal surpluses probably realize, even though the importance of taxation has nothing to do with a currency-issuing government’s financial capacity to spend.

At the most fundamental level, it is the imposition and enforcement of a tax obligation that ensures acceptance – and therefore viability – of the currency. By imposing taxes and other liabilities (e.g. fines, fees) that can only be extinguished with currency or reserves, the currency-issuing government ensures a willingness within the community to accept the currency in payment for goods and services. Since households and businesses need the currency in order to pay their taxes, they will be willing to accept it in payment for goods and services. Without a tax basis, the currency’s viability would not be assured.

Taxes also have other purposes. They are used to moderate demand (i.e. the level of spending on goods and services), influence behavior (e.g. taxes to discourage environmentally damaging activity or subsidies to encourage investment in renewable energy), and to modify the distributions of income and wealth.

 
Further reading

Academic treatments of the topic for scholarly readers:

Stephanie Kelton (Bell), ‘Can Taxes and Bonds Finance Government Spending?’, Journal of Economic Issues, 2000, vol. 34, pp. 603-20.

Beardsley Ruml, ‘Taxes for Revenue are Obsolete’, American Affairs, 1946, vol. 8, no. 1, pp. 35-39.

Related posts for general readers:

Government Spending or Lending Logically Precedes Tax Revenue
MMT in Simple Parables
Government Deficits and Net Private Saving
What Everyone Should Known About Budget Deficits and Public Debt
Exercising Currency Sovereignty Under Self-Imposed Constraints