Taxes and government production

There is a paradox in how we talk about "paying for" what the government produces. Yes, taxes do pay for government production. And no, taxes do not pay for government production. Wait, what?

As best I can tell, Modern Monetary Theory scholars* stress the idea that taxes do not pay for government produces in a "financial" sense: unlike a household or a firm, government does not collect taxes to obtain money to spend on government production. A household or a firm must obtain money, via revenue, borrowing, or theft, before it can spend it. A government need not do so; to the extent that the government says it does need to collect money before it spends it, the government is at best disingenuous and at worst deceptive. Financially — and this qualifier is crucial — the government spends whatever it chooses to spend, regardless of ex ante taxation or borrowing. A household or firm cannot choose to spend money it has not already obtained; a government might choose to spend only the money it has previously obtained, but it can choose not to.

*I will repeat my usual disclaimer: I am not a scholar of MMT; any mistakes in my present description of MMT ideas are my own.

I suspect that MMT scholars stress this financial freedom precisely because not only governments but orthodox economists, while they formally acknowledge government's financial freedom, either don't understand this freedom — a lot of economic theory depends on a financial budget constraint to make any kind of sense — or they don't want people to intuitively grasp the government's financial power. What is to become of the captains of industry, the titans of finance, if their years of hard work accumulating money can be duplicated or undone in seconds by some faceless downclass bureaucrat in a cheap suit? Worse yet, what if the unwashed masses catch on and start, gasp! voting on that basis? No, such nonsense simply will not do.

But of course even that the government has financial freedom, i.e. it can spend as much or as little money as it pleases, the government does not have "real" freedom: it cannot choose to escape opportunity costs. Especially when the economy is at full employment, anything the government creates money to produce means using that money to reallocate real labor and capital away from other production. At full employment, government spending on one thing, regardless of the source of the spending, means giving up something else.

Governments usually produce public goods, and the opportunity costs of public goods are harder to distribute than are the opportunity costs of private goods. Suppose a firm produces a private good, a new and improved widget with extra frobulousness. The firm improves society if and only if individual consumers individually choose to buy its widgets instead of now unfashionable and obsolete doodads and gewgaws. Ideally, the private firm merely poses the option: the individual consumer decides whether the new option is worth the opportunity cost, and what the opportunity cost actually is in real terms. And we know when the firm produces the optimal quantity of new and improved widgets precisely when the marginal consumer is indifferent between the new widget and the next best choice. With apologies to Landseer and à Kempis, the firm proposes, the consumer disposes.

Public goods simply do not work that way, as economists orthodox and heterodox all know: the math is clear and unequivocal. Individual consumers cannot individually choose how much of a public good they receive: all consumers receive benefit from all production of a public good, regardless of their individual preferences. If the government produces clean air, I cannot help but breathe it.

Thus, the government must distribute the opportunity costs. They can do so in two ways: increase or keep constant the supply of money and let everyone's money purchase less stuff per dollar, i.e. no taxation and some inflation, or decrease the supply and let everyone's money retain its purchasing power, i.e. some taxation and no inflation, i.e. price stability.* So in the sense of the distribution of opportunity costs, taxes do in a sense "pay for" government production.

*Strictly speaking, there is a continuum between zero taxation and zero inflation.

On the one hand, government has financial freedom; on the other hand, the government has real constraints. On the gripping hand, there are some circumstances where government spending neither requires taxation nor generates inflation (or at least not nearly as much as it might otherwise do). When government spending promotes short run or long run real economic growth, the economic growth itself "pays for" government spending in both the financial and real sense. In the short run, when real economic output is below potential — i.e. under recessionary conditions of less than full employment, especially when the recession has been caused or exacerbated by collapse of the money supply as during the Great Depression — government spending causes an increase in both financial and real economic activity. The injected money just keeps flowing; it does not (all) need to be leaked back out by taxation, and the increase in real economic activity absorbs the extra spending without causing (too much) inflation.

Similarly too with long run economic growth. Government spending in research and development, especially for the military, initiates much (if not almost all) of the growth of inventive technology. (See e.g. Doing Capitalism in the Innovation Economy by William H. Janeway.) Again, the spending is "paid for" by the increase in real economic activity.

Many critics of MMT argue that the above exposition is just warmed-over bog-standard Keynesian macro. Perhaps. If so, the profession of economics has been trying to at best downplay and at worst obfuscate its importance and relevance not just to the general public but to undergraduate students of economics. I know: I just finished an undergraduate and graduate economics education, and I found the claims of MMT were both shocking and obvious in retrospect.

Even the Holy Bearded One says in his own Macroeconomics textbook that the government should run a balanced budget on average (my copy is in my office; citation to follow). But this cannot be so. In an ideal world where we always have zero inflation and no short-term fluctuations, to preserve perfect price stability, the amount of money flowing through the economy* must increase as long-run potential output increases. Since money cannot flow arbitrarily quickly, the overall supply must increase, so either the banks create it or the government has to create new money.

*Technically the money supply times the velocity of money.

We could, I suppose, allow the private banking system complete control over the flow of money. When unconstrained by government regulation, complete private control of money generally has not worked worked all that well. Seriously. It's a Bad Idea. If we want to make the foundation of economy the government's power to collect taxes, then the government must run a deficit on average.