Is It True That the Government Can Spend Before Taxing?

By J.P. Koning

Does government spending precede taxation? This is a claim I sometimes hear on Twitter and elsewhere. More specifically, the idea is that a government need not wait for taxes or bonds to bring in resources prior to spending on programs and investments. Rather, spending occurs first, and then taxes (and bonds) follow.

This “renegade” view is opposed to the more traditional claim: governments have to raise money via taxes and bonds, and only then can they spend.

In this article, I hope to show that whether the renegade claim is true depends on how you choose to define the word "government.”

Let's start by defining “government” as both the central bank and the spending authority. In the U.S. case, the former is the Federal Reserve and the latter is the Treasury. This combined entity has a monopoly on the creation of two key monetary instruments: U.S. dollar banknotes and reserves. Given this monopoly, all payments in the U.S. are ultimately settled using a transfer of one of these two instruments. This includes the payment of taxes.

It is easy to show that government spending precedes taxes. At the beginning of time, there are no banknotes and reserves. How can a citizen pay his or her taxes? By definition, the government has to spend them into existence. One arm of the government, the Fed, must purchase an asset from the public with either banknotes or reserves, thus giving birth to money. Only then are citizens able to pay Uncle Sam their dues.

Stephanie Kelton, an economist who champions the renegade view, better explains things this way:

Indeed, the entire process of taxing and spending must, as a matter of logic, have begun with the government first creating (and spending) new government money. How, after all, could a population settle its tax liabilities using the government’s money before the government had made its money available? In other words, the government’s purchase of goods and services using newly-created money must first have supplied the citizens with the means with which to pay taxes.

Thus government spending does indeed precede taxation.

Now let's redefine what we mean by “government.” Instead of being a combination of the two institutions, we might define the government as the spending authority — in the U.S. case, the Treasury. The central bank — that is, the Federal Reserve — is not included in this definition. When government is defined this way, it is no longer the case that government spending creates money. 

Historically, all U.S. government spending has occurred through checks and wire transfers placed through a single account that the Treasury keeps at the Fed. In theory, the Treasury could simply create money by having the Fed print new reserves “out of nothing” and put them in the Treasury's account. And then the Treasury could spend this money into the economy prior to having to earn tax revenues (or issue bonds), vindicating the renegade claim. But laws prevent the Fed from complying with this order. It cannot create free money for the Treasury.

This leaves just two ways for the Treasury to spend. It must wait for tax income to roll into its account at the Fed. Or, it must issue bonds and have the proceeds be deposited into its account.

Under this second definition, you can see that the traditional view holds. Payment of taxes by citizens no longer requires that the government first create money. Rather, the opposite is true. The government — the Treasury — is legally prevented from creating money. Another institution, the Fed, is responsible for that. (More specifically, the Fed creates money by purchasing assets from the private sector.) Only after citizens pay their taxes and funds roll into its account will the government have money to spend. 

To sum up, when someone suggests that government spending is "independent of any prior revenue such as taxes or borrowing," they are right. But only if we define “government” to include both the Fed and the Treasury. They are wrong if we define “government” to include only the Treasury. In this case, government spending — that is, Treasury spending — is only possible because of taxes or borrowing. 

More generally, this example shows how what we perceive to be true depends on how we initially categorize things. Disputes may arise not because people fundamentally disagree, but because they are unwittingly using a different way of pre-digesting the world.

That being said, a certain way of categorizing the world may be more useful for a certain task than others. I would not be committing any logical errors if I were to insist on categorizing all colors as red and not-red. But if I told my kids they should sort their crayons using my categorization they'd look at me a bit strange. However, my red vs. not-red dichotomy would be a useful way to categorize frogs in a jungle — say, because the red frogs are poisonous but the rest are not.

Let's bring this conversation back to where it started: the different ways of defining government and its bearing on spending. Say that Donald Trump is up late at night and spots a tweet with the renegade slogan that “government spending precedes taxation.” Inspired, Trump issues a proclamation the next day commanding the Fed to buy Greenland on his behalf for $1 trillion. He'd find pretty quickly that the law prevents the Fed from complying. There are surely advantages to the renegade way of classification, but there are also limits to its usefulness.

 

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J.P. Koning

J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art.

Koning earned his B.A. in Economics from McGill University.