What do taxes pay for?

The report of the National Commission of Audit proposes a set of 'principles of good government'. One of them is:

Assure value for taxpayers’ money and ministerial responsibility. Governments spend taxpayers’ money not the government’s money.

(Chair of the Commission of Audit, Tony Shepherd)

This principle reflects the terms of reference given by the Australian Government to the Commission, which state that 'government should have respect for taxpayers in the care with which it spends every dollar of revenue'.

What do Australian Government taxes pay for?

Nothing, actually. From the perspective of Modern Monetary Theory, the Australian Government, as the sovereign issuer of a fiat currency, does not spend money raised by taxes.

The Australian Government spends by crediting the bank accounts of recipients of payments. This is effected by crediting the relevant banks' reserve accounts at the Reserve Bank by the same amount. These credits are accounting entries, created by keystroke.

When a person pays taxes to the Australian Government, they direct their bank to debit their account in favour of the Government and, in doing so, the bank also directs the Reserve Bank to debit its reserve account by the same amount. More keystrokes.

The Australian Government is not constrained by the need to have reserves of gold or another nation's currency at hand before it can spend. It doesn't need those debit keystrokes to happen before it can do the credit keystrokes. If anything, the rest of us need the Government's issuance of currency into the payments system before we can make the payments that discharge our tax liabilities, not the other way around.

Although they don't pay for anything, taxes are crucially important for the Australian Government and other agents in the economy, for a number of reasons.

First, taxes ensure that the Government's money will be used. If you're worried that the dollars in your bank account are nothing more than electronic figments of accounting, be assured that the Australian Government will accept them in payment for tax liabilities. If you don't pay taxes when they're due, you're in trouble. That's a good reason to go out and produce goods and services and get some of that money. And so will other persons, and being able to buy their goods and services is another good reason to get some money.

Secondly, taxation regulates aggregate demand. Taxes take money out of the economy – creating some space for the Government to spend on goods and services without having to bid up private sector spenders, and hence avoiding undue inflation.  

Thirdly, taxation redistributes the spending power of economic agents. Obviously, money is not distributed equally throughout the economy, and taxes take more from some economic agents than from others. Taxes do not redistribute in the sense that the actual dollars taken in tax get paid out again in payments, but they do change what taxpayers individually have to spend, and hence the distribution of spending power throughout the economy. 

Last and not least, taxes affect behaviour. Where an activity comes with a tax liability, people tend to do less of it: think of so-called 'sin taxes' that discourage the purchase of cigarettes and alcohol. And where one activity amongst several similar activities is treated preferentially (that is, it's lightly taxed, or not taxed at all), that activity is encouraged: think of the tax treatment of incomes and housing.

Interest from money in the bank is taxed; a gain in the value of owner-occupied housing is not – so people with money to spare are encouraged to put it into their housing, rather than the bank. Also, gains from capital are taxed at half the rate of incomes earned by work – so people are encouraged to find clever ways of turning their income into capital, such as borrowing to buy a (hopefully) appreciating asset (in particular, rental housing that's appreciating with the help of those owner-occupier who are encouraged to spend spare money on housing).

It should be said, governments have an ambivalent attitude to this function of taxation: as a matter liberal economic principle, rational individuals are best placed to decide what activities they'll undertake, and governments should not try to interfere in the decision – hence the dissatisfaction with 'inefficient' stamp duties, which are levied as a big hit upon the sale of a property, and can discourage people from selling when it would otherwise suit them to do so. By contrast, a tax like a broad-based land tax, levied on the unimproved vale of land, does not interfere with individual decision-making, except to generally encourage the productive use of land.

In any event, notwithstanding these matters of principle, the Australian Government does engage in behaviour-altering taxation a lot, as the distorted shape of our housing system shows.

All these things are what taxes do; what they don't do is pay for Australian Government spending. The Australian Government does not spend taxpayers' money. It really does spend 'government money', and the extent to which it spends that money for beneficial public purposes is a measure of our democracy.

What is a sustainable surplus?

Chair of the National Commission of Audit, Tony Shepherd, laments the widespread criticism of the Federal Budget. He says:

I wish people could... stand back, look at the overall picture of the Commonwealth budget and rather than say 'don't touch me', say 'what can be our contribution to a sustainable surplus'.

The terms of reference for Shepherd's Commission of Audit included that it 'make recommendations to achieve savings sufficient to deliver a surplus of 1 per cent of GDP prior to 2023-24.'

So what is a sustainable surplus?

There's probably no such thing, at least for the Australian economy. Government deficits are more sustainable than surpluses.

First, let's get clear on what a surplus is, and what a deficit is. Each refers to the government's net income over a period (a year). If the Australian Government's income (primarily taxes) is more than its spending, the Government is in surplus; and if its spending is more than its income, it is in deficit.

Of course, one person's spending is another person's income, so if the Australian Government is in surplus, everything that's not the Australian Government (households, firms, other governments) must, by identity, be in deficit.

(This means, incidentally, that rather than saying a government 'delivers' a surplus, it is better to say that it 'takes' or 'extracts' a surplus.)

We can narrow down that broad non-government sector by distinguishing an external sector (ie foreign households, firms and governments) from the Australian private sector.

For any given period, one (or two) of the three sectors can be in surplus – and two (or one) in deficit. Not all of them can be in surplus, or in deficit, at once. Their total surpluses and deficits for the period must net to zero.

In the case of Australia, what we pay to the external sector is nearly always more the income we receive from it (we have a current account deficit). With that in mind, when the Australian Government takes a surplus, the Australian private sector must be in deficit – paying out more than it receives in income.

The Australian private sector can do this by running down stocks of money accumulated in previous periods of Australian private sector surplus (that is to say, periods of Australian Government deficits).

This cannot be sustained for long. Theoretically, if the Government persisted bloodymindedly in taking surpluses year after year, the private sector would end depleting all its net financial assets, then start offering up real assets (houses, cars, the shirt off your back) to the voracious Government. More realistically, financially constrained households and firms would try to shore themselves up individually by spending less and saving more, thus reducing overall income and economic activity.

By contrast, when the Australian Government is in deficit, its spending is not financially constrained, because it issues the currency. With an Australian private sector that is inclined to save Australian dollars and other net financial assets, and an external sector of trading partners pleased to accumulate Australian net financial assets, an Australian Government deficit is the sustainable and appropriate way to promote economic activity.

What the Commission of Audit says about housing

The much anticipated report of the National Commission of Audit was released yesterday.

 (Chair of the National Commission of Audit, Tony Shepherd)

Of the comment generated so far, we reckon Fairfax's Peter Martin has nailed it with his criticism of the partial nature of the Audit: it looks at government spending, but not really at tax, and certainly not at tax expenditures.

Martin gives the example of retirement incomes; we can also see the flaw in the Audit in what is says about housing.

The Audit zeroes in on spending on Rent Assistance ($3.6 billion pa), affordable housing – in particular, the National Affordable Housing Agreement ($1.3 billion pa), which funds social housing, and the National Rental Affordability Scheme ($1.5 billion over four years) – and alleviation of homelessness ($159 million pa). It frames these as 'programmes that duplicate State responsibilities' (on the basis that 120 years ago, it did not occur to the drafters to include 'housing' in section 51 of the Australian Constitution).

The Audit notes the 'limited success' of these programs in delivering affordable housing and reducing homelessness, and so considers that the Commonwealth should pull back and 'limit its involvement in this area to providing rent assistance to income support recipients'. That includes social housing tenants, who'd henceforth be paying market rents. There'd be no housing agreements or grants to the States and Territories for social housing or affordable housing; the National Rental Affordability Scheme would go too.

The Audit mentions the Henry Review in support of the case for extending Rent Assistance and market rents to social housing; it does not mention, however, that the Henry Review also recommended an additional payment for 'high needs clients' of social housing.

And that's it. Because it doesn't really look at taxes, and certainly not tax expenditures, the Audit misses the really big housing subsidies: the $30 billion pa benefit for owner-occupiers effected by not taxing their capital gains, imputed rents or land values; and the $7 billion pa benefit for landlords effected by not taxing income spent on the costs of speculation (negative gearing) and only half-taxing the gains of speculation.

These benefits have encouraged households with money (or credit) to spare to spend it on their own housing, or on speculating on rental housing, driving up prices and limiting the effectiveness of the Government's own spending on social housing and affordable housing and homelessness alleviation.

The Audit has missed the real problem in housing policy, and the opportunity of offering real solutions.