Taxes are for Redemption, Not Spending

Fiscal austerity has become the mantra, the solution to the world's problems. Unemployment and slow growth? More austerity. High interest rates and rising debt ratios? More austerity. Inflation? More austerity. Deflation? More austerity. Budget deficits or trade deficits? More austerity. One size fits all. In one short article, it is impossible to deal with all of the arguments for fiscal austerity. In this piece I'm going to tackle just one justification: that government faces a budget constraint similar to that of households. Hence, even if we wanted to loosen fiscal policy, we might not be able to do so due to financial constraints. Indeed, by tightening now we create fiscal space that might be needed in the future. In the orthodox view, government's spending is constrained by the sum of its tax revenue, bond sales, and money creation. Bond sales, in turn, are limited to the nongovernment sectors' willingness to lend to government; as sales increase, the interest rate required to bring forth buyers rises – which eventually creates a vicious cycle of rising rates and bigger deficits. Running the printing presses to finance deficits raises the spectre of inflation, with too much money chasing too few goods. Hence, prudency dictates relying on taxes to pay for most government spending. The belief that government needs tax revenue to pay for most (or even all) of its spending is nearly universal. It wasn't always so. At the end of WWII it was commonly understood by economists from the right (Milton Friedman) to the left (Abba Lerner) that taxes are not needed for revenue purposes. Indeed, the Chairman of the NY Fed, Beardsley Ruml, even wrote a piece entitled “Taxes for Revenue are Obsolete”. None of these economists were arguing that we should dispense with taxes – which can be used for a variety of purposes. Rather, they recognized that unlike a household or firm, government does not need income to finance its spending. We can go even further and argue that government needs to spend before it can receive income. Indeed, while everyone looks at tax “revenue” as the government's equivalent to “income”, this view actually prevents understanding. We should instead understand “revenue” as “redemption”. As I'll show, from the time of the American colonies through the early postwar period, this is the way that many regarded taxes.