Many South Africans wrongly believe that government spends “taxpayer money”. In this article I explain how the state creates new money when it spends, and how taxation just destroys money that the state has already spent into existence.
The South African Reserve Bank is the organ of state which is the monopoly issuer of Rands. This means that it has sole right to print Rand denominated banknotes, mint Rand denominated coins or digitally mark up the amount of commercial bank reserves held in banks’ reserve accounts at the SARB.
Banknotes, coin and bank reserves are called base money or M0 money supply. Only the SARB can issue base money. While banknotes and coin exist outside the SARB, digital bank reserves never leave accounts held at the SARB.
The SARB creates money by expanding its balance sheet on both the assets and liabilities sides through purchasing financial assets. When the SARB buys a financial asset (repos, bonds etc) from a bank for example, it creates Rand reserves (SARB’s liability) by marking up bank reserve accounts in exchange for that asset. This is one way that the state increases base money supply. Another way that the state expands base money supply is when treasury spends money into the private sector (more on that later).
Base money is not the only money in supply though. The SARB grants charters to commercial banks which allows them to create bank deposits (broad money) when they issue loans. When commercial banks issue loans, they are also expanding their balance sheet 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 (bank’s asset) in exchange for marking up the deposit in your bank account (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 from them. Because banks are required to hold a certain ratio of bank reserves 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 the SARB (base money creation). Because banks are continually lending, and backing that lending with reserves, broad money and base money supply is constantly increasing, as the graph below shows.
When loans are repaid, credit is destroyed. When you pay back the amount you owe the bank, the bank reduces its assets (you owe them 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 SARB, base money (M0) is destroyed. If money supply is expanding, as shown in the graph above, that indicates that banks are lending (creating money) at a greater rate than money is being paid back to them (destroying money).
But bank lending is not the only way that money is created and destroyed. Money is also created when government spends on procuring goods and services from the private sector.
Government has accounts at the SARB. The amount in government’s accounts at the SARB is not counted as part of the money supply, so when government spends money into private sector bank accounts, both base money and broad money supply increases as I will shortly explain.
All government spending is done from its Exchequer account at the SARB. As government spends from its Exchequer account at SARB, it creates an overdraft which is cleared by the end of each day by drawing money from government’s Tax and Loan accounts held at commercial banks (destroying money). At the end of each day, the balance in government’s Exchequer account at the SARB is 0.
Let’s imagine government spends R1 million into company X’s account at ABSA. Firstly, the SARB credits ABSA’s reserve account at the SARB with R1 million in reserves (creating base money). Simultaneously, ABSA credits company X’s account at ABSA with R1 million (creating broad money). That (and other) spending creates an overdraft in government’s Exchequer account at the SARB, which at the end of the day is rebalanced to 0 by drawing down on governments Tax and Loan accounts at the commercial banks (destroying money).
When taxes are paid, the opposite occurs and money is destroyed. Let’s assume Company X pays R100 000 in tax to SARS. ABSA will reduce the deposits in Company X’s account at ABSA by R100 000 and credit government’s Tax and Loan account at ABSA with that amount. No change in money supply so far. The R100 000 will sit in government’s Tax and Loan account at ABSA until government spending (money creation) from its Exchequer account at the SARB creates an overdraft, which requires government to draw down on its Tax and Loan account at ABSA. This destroys broad money and base money as ABSA will mark down the deposits in government’s Tax and Loan account (destroying broad money), and SARB will mark down the reserves in ABSA’s reserve account at SARB by the same amount (destroying base money).
Since taxation results in the destruction of bank reserves, and bank reserves can only be created by the state spending Rands into existence, either through government spending on goods and services or through SARB buying financial assets, it follows that the state first has to spend Rands into existence before it can tax them out of existence. As the state must spend money into existence before it can tax it out of existence, it follows that the purpose of taxation cannot be to fund government spending, as is commonly believed.
Taxation doesn’t fund state spending. State spending funds taxation.
Tax is necessary, but for other reasons:
- Tax creates fiscal space for more spending by government, because it removes money from private sector bank accounts, reducing demand and thus the possibility of demand pulled inflation.
- Tax increases the value of the currency by reducing its supply, and creating demand for it. You need Rands to pay tax.
- Tax is useful for influencing consumption and investment behaviours. A tobacco tax for example might discourage smoking.
So next time you hear someone talking about taxpayer money funding government, educate them. You are welcome to share this article.
For a more in depth explanation of how to optimise taxation policy please read Optimising tax policy: Why South Africa can afford to reduce all taxes on our poor, middle class and productive industries.
If you’d like to read a great academic paper on the topic of the real purpose of taxation, this paper by leading Modern Monetary Theory scholar, Professor Randall Wray, called “Taxes are for redemption, not spending” is illuminating. http://wer.worldeconomicsassociation.org/files/WEA-WER-7-Wray.pdf
If you like what I’ve written, please consider contributing to my Patreon account. patreon.com/buddywells
Till recently, I have self funded my research and writing with my income as a musician and teacher. With your help, I can dedicate more time and effort to being an activist for real change in the lives of our people.
Don’t forget to follow to receive email notification of new posts.