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.