14/08/2017 08:33 BST | Updated 14/08/2017 08:34 BST

This Is What Your Tax Really Pays For

Like me, you probably thought the government collects tax to pay for all manner of public services: police, soldiers, power stations, roads, doctors, nurses, teachers, street lights etc. You name it, your tax pays for it!

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Yep. You read that right.


Like me, you probably thought the government collects tax to pay for all manner of public services: police, soldiers, power stations, roads, doctors, nurses, teachers, street lights etc. You name it, your tax pays for it!

Except, it doesn't.

Like me, you've probably heard a lot over the years about the role tax plays in the economy, why we should pay it and who should pay what amount and when.

This often boils down to one thing: tax pays for public services and the government has to collect tax first before it can pay for public services. Because how else does it get its money to pay for those things? Duh!

This is at best misleading, because it's inaccurate and illogical. At worst, it's a lie promoted by those who stand to profit from it. But we've swallowed it because it sounds reasonable.

1. The government collects tax.

2. Public services have to be paid for.

3. Therefore the government collects tax to pay for public services.

It seems to make sense because it appears to explain why we pay tax.

If you don't hear those three points spelled out like that, you might hear instead the nation's finances being compared to a household's finances: Salary paid in, bills paid out; Tax paid in, public services paid out.

This "good housekeeping" analogy works well except for one crucial detail: it's wrong.

The nation's finances are nothing like a household's finances because a household has a fixed income e.g. salary per month (although it might of course grow over time). The government, however, does not have a fixed income at all. Even more importantly, it can create its own income (money/credit) on demand! And it doesn't do that by collecting tax.

A Super-Platinum credit card

Instead, whenever the government needs to pay someone e.g. a nurse, a doctor or an armed police officer, it simply credits the accounts of the relevant public services. In other words, the government has, in effect, a credit card with unlimited credit.

So don't be fooled by that "good housekeeping" analogy a moment longer. Because it's distracting and disabling you from understanding how the government really pays for things and what your tax really pays for.

The truth is thankfully far simpler

Here's what is true: the government does have to collect tax, and public services do have to be paid for. But the government does not collect tax in order to fund public services, in fact, tax is collected for a very different reason.

This leads to two questions

Firstly, if the government doesn't collect tax to pay for public services, where does the money come from to pay for those things?

Secondly, if tax isn't collected to pay for public services, what is it used for?

Both good questions!

The first can be answered by asking you a simple question: where do you get your money from?

The bank.

So why would you think the government doesn't do the same? It does. In this case, the government gets its money from the Bank of England: the UK's central bank. The government can go to the Bank of England and instruct it to create whatever amount of money it needs.

It can then use that money to buy goods and services from the private sector and use it to build schools, hospitals, roads, power stations: the things we all rely on and need for our society and economy to function.

All nations with their own central bank and their own currency have the ability to create their own money and use it as they see fit. America can do this. Iceland can do this. Japan can do this. The UK can do this.

However, Greece, France and Germany - for example - cannot do this because they use the Euro and are therefore dependent on the European Central Bank to create money for their economies.

Which means...

Since our government can create its own money, there is in fact no need to borrow it from private banks. It can just "borrow" from the Bank of England which is what happens in the case of quantitative easing. Although it wouldn't really be "borrowing" in the usual sense because it owns the Bank of England, so would be borrowing from itself. Either way, if the government doesn't need to borrow money from private banks, it doesn't need to pay them interest.

But hang on a minute...

The UK government does borrow money from private banks and it does pay a huge amount of interest on those loans (£33 billion in 2015/16).

But it doesn't actually need to because it can create its own money. So why would it borrow from someone else and pay them interest (profit for the lender) instead of creating its own money? It makes no sense.

The simple answer is that our government only borrows money at the moment because this is how the politicians have decided to set up the banking system.

It's possible that the private banks may have, in some way, also encouraged our politicians to rig the banking system in their favour. Who can say! But since the banks make a profit from (creating and) lending money, it stands to reason that the more they can lend to the government, the more profit they can make for themselves.

If we don't like the way the system works...

We can change it. We must remember that the government doesn't always borrow money from private banks. No. As part of everyday life, it creates whatever money is needed to pay for public services, within the confines of the budget that it has imposed on itself, without borrowing a penny or first having to collect tax.

It also does this in emergency situations. For example, to help finance World War 1, and again much more recently to help get us out of the financial crisis of 2008/9. The government instructed the Bank to create hundreds of billions.

It then used that money to buy back government bonds from the private finance markets and in the process inject money into that sector of the economy, in the vain hope it would trickle down to the rest of the economy.

Did the government tax anyone before instructing the Bank of England to create that money?

No. It never collected a penny in tax to pay for bailing the banks out. There was no "tax and spend".

Which leads us to...

Why pay tax?

Because the government demands that it is paid. Don't mistake that statement for being a "because I said so" answer. There's much more to it than that.

The government demands we pay tax to give our currency, the Pound, its value. If, instead, the government allowed us to pay our tax in dollars, then we all might rush off and exchange all our Pounds for dollars and start using those instead to buy and sell things and pay tax. But if we did that, what would happen to all those lovely Pounds the government created? They would devalue because people would stop using them.

That could, in turn, reduce the government's ability to pay for anything in the economy and leave it little choice but to use dollars too, which it would of course have to borrow from someone else and pay interest on.

But the government doesn't want the Pounds it created to devalue and go out of use, because that would mean that it couldn't pay for public services like roads, electricity, police, schools and hospitals: the things the economy relies on.

That's not the only reason we pay tax

Tax also helps the government control inflation. Collecting tax literally removes money from circulation, stopping it from being spent and therefore limiting the amount of trade that takes place in the economy. If the government collects taxes in a measured way - not taxing too much too quickly - it can help keep inflation in check.

Interest rates have a similar purpose. The higher the interest rate, the more expensive it is for businesses and individuals to borrow money and then spend it. The less they borrow and spend, the less activity there is in the economy and the less likely it is for inflation to spiral out of control.

But it works both ways

It's not just tax that can influence inflation and the amount of economic activity going on. If there's too much money being kept in savings accounts, the amount of money in circulation also shrinks and therefore the amount that is spent in the economy shrinks.

So, now you know the government can create its own money and what tax is actually used for, let me ask you this...

If you had the power to create your own money, and invest it in whatever you wanted, would you still go and borrow money from a private bank, knowing you'd have to pay them a huge amount of interest?

No. Of course not.

"What madness!" you would cry.

But that's exactly what our government is doing even though it doesn't need to.

It doesn't have to be that way.

We can create our own money if we want to.

Just think what we could do with £33 billion a year instead of paying it in interest to other people!

(Many thanks to Charles Adams for fact checking this article.)