Understanding why governments tax
In a fiat monetary system the currency has no intrinsic worth. Further the government has no intrinsic financial constraint. Once we realise that government spending is not revenue-constrained then we have to analyse the functions of taxation in a different light. The starting point of this new understanding is that taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.
In this way, it is clear that the imposition of taxes creates unemployment (people seeking paid work) in the non-government sector and allows a transfer of real goods and services from the non-government to the government sector, which in turn, facilitates the government's economic and social program.
The crucial point is that the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending. Accordingly, government spending provides the paid work which eliminates the unemployment created by the taxes.
So it is now possible to see why mass unemployment arises. It is the introduction of State Money (government taxing and spending) into a non-monetary economics that raises the spectre of involuntary unemployment. As a matter of accounting, for aggregate output to be sold, total spending must equal total income (whether actual income generated in production is fully spent or not each period). Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages).
Unemployment occurs when the private sector, in aggregate, desires to earn the monetary unit of account, but doesn't desire to spend all it earns, other things equal. As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment. In this situation, nominal (or real) wage cuts per se do not clear the labour market, unless those cuts somehow eliminate the private sector desire to net save, and thereby increase spending.
The purpose of State Money is for the government to move real resources from private to public domain. It does so by first levying a tax, which creates a notional demand for its currency of issue. To obtain funds needed to pay taxes and net save, non-government agents offer real goods and services for sale in exchange for the needed units of the currency. This includes, of-course, the offer of labour by the unemployed. The obvious conclusion is that unemployment occurs when net government spending is too low to accommodate the need to pay taxes and the desire to net save.
This analysis also sets the limits on government spending. It is clear that government spending has to be sufficient to allow taxes to be paid. In addition, net government spending is required to meet the private desire to save (accumulate net financial assets). From the previous paragraph it is also clear that if the Government doesn't spend enough to cover taxes and desire to save the manifestation of this deficiency will be unemployment. Keynesians have used the term demand-deficient unemployment. In our conception, the basis of this deficiency is at all times inadequate net government spending, given the private spending decisions in force at any particular time.
For a time, inadequate levels of net government spending can continue without rising unemployment. In these situations, as is evidenced in Australia over the last several years GDP growth can be driven by an expansion in private debt. The problem with this strategy is that when the debt service levels reach some 'threshold' percentage of income, the private sector will attempt to restructure their balance sheets to make them less precarious and as a consequence the demand for debt slows and the economy falters. In this case, any fiscal drag (inadequate levels of net spending) begins to manifest as unemployment.
The point is that for a given tax structure, if people want to work but do not want to continue consuming (and going further into debt) at the previous rate, then the Government can increase spending and purchase goods and services and full employment is maintained. The alternative is unemployment and a recessed economy.
Accordingly, the concept of fiscal sustainability does not entertain notions that the continuous deficits required to finance non-government net saving desires in the currency of issue will ultimately require high taxes. Taxes in the future might be higher or lower or unchanged. These movements have nothing to do with 'funding' government spending.
This blog series will conclude with Fiscal Sustainability 101, Part 3d