BUDDY WELLS: Taxes don’t fund government spending. Government spending funds taxes

The Reserve Bank is the organ of state that is the monopoly issuer of rand. The parliament of SA has granted the central bank the sole right to print rand-denominated bank notes, mint rand-denominated coins, or digitally mark up bank reserves held in the banks’ reserve accounts at the Reserve Bank.

Bank notes, coin and bank reserves are called base money or M0 money supply. Only the Reserve Bank can issue base money. While bank notes and coins exist outside the Reserve Bank, bank reserves never leave accounts held there.

The Reserve Bank creates money by expanding its balance sheet on both the assets and liabilities sides, through purchasing financial assets. When it buys financial assets (mainly repos and bonds) from the private sector, it creates rand reserves (the Reserve Bank’s liability) by marking up bank reserve accounts in exchange for that asset. This is one way the state increases base money supply. Another way is when the Treasury spends money in the private sector (more on that later).

Base money is not the only money in supply, though. The Reserve Bank grants charters to commercial banks, allowing them to create bank deposits (broad money) when they issue loans. When commercial banks issue loans they are also expanding their balance sheets on both sides by buying financial assets. When a bank issues you a loan it purchases your signed loan agreement to pay the bank the principal plus interest (the bank's asset) in exchange for marking up the deposit in your bank account (the bank's liability).

By marking up the deposit in your bank account your bank is creating broad money (credit). Your bank deposit is the bank's promise to pay you that amount in cash (base money) should you demand it. Because banks are required to hold a certain ratio of bank reserves (bank assets) to back their liabilities (deposits), when banks issue loans (broad money creation), they must then look to borrow the required reserves (to back those increased deposits) from other banks or from the Reserve Bank (base money creation).

As banks lend and back that lending with reserves, broad money and base money supply increases. When loans are repaid money is destroyed. When you pay back the amount you owe the bank it reduces its assets (you owe it less), and its liabilities (you have less money in your bank account). Broad money has been destroyed. Similarly, when banks repay money owed to the Reserve Bank, base money (M0) is destroyed. SA broad money supply is expanding, indicating that banks are lending (creating money) at a greater rate than money is being paid back to them (destroying money).

Bank lending is not the only way that money is created and destroyed. Money is also created when the government spends on procuring goods and services from the private sector. The government has accounts at the Reserve Bank. The amount in the government’s accounts is not counted as part of the money supply, so when central government spends money into private sector bank accounts both base money and broad money supply increase.

The central government spends into the private sector (money creation) from its exchequer account at the Reserve Bank by running up an overdraft (money owed to the Reserve Bank), which is cleared at the end of each day by drawing down on the government’s tax and loan accounts held at commercial banks (destroying money).

Taxation results in the destruction of bank reserves, which can only exist once the state has spent them into existence, either through government spending on goods and services or through the Reserve Bank buying financial assets. The state first has to spend Rands into existence before it can tax them out of existence. It follows that the purpose of taxation is not to fund government spending, as is commonly believed.

Tax is necessary and essential though, for other reasons:

• Tax creates fiscal space for more spending by government, because it deletes bank deposits, reducing demand and thus the possibility of demand pulled inflation.
• It increases the value of the rand by reducing rand supply and increasing demand for rand. You need rand to pay tax.
• It is useful for influencing consumption and investment behaviours. A tobacco tax might discourage smoking, for example.
• Tax can prevent extremes in inequality so that individuals do not wield undemocratic power and influence over public institutions.

This means that while demand is too low and inflation is cost pushed, the state has space to reduce those taxes, which add to our productive sector’s costs while reducing demand for our goods and services, and deficit spend more rand into the private sector.

Our current policy of offsetting government spending (rand creation) with taxes like the fuel levy, VAT and income tax on our poor and middle classes (rand destruction) is counterproductive while inflation is not demand driven and demand is too low.

There are two alternatives to taxes: the government can either offset its spending with high-yielding bond sales or with low-interest loans from the Reserve Bank. Because the rand issuing state does not rely on the private sector for rand, selling rand-denominated bonds to the private sector is beneficial only in that:

1. Bond sales offer the private sector extremely safe interest-bearing assets.
2. Bond sales reduce private-sector liquidity, helping the state (the Reserve Bank) maintain interest rates.
3. Bond sales to nonresidents can offset balance of payments shortfalls and maintain the rand’s exchange value.

• Wells is a public finance policy activist and economics blogger